New York Venture Hub – LexBloghttps://www.lexblog.com
Legal news and opinions that matterSun, 15 Sep 2019 09:15:35 +0000en-UShourly1https://wordpress.org/?v=4.9.11https://www.lexblog.com/wp-content/uploads/2018/10/cropped-favicon-1-32x32.pngNew York Venture Hub – LexBloghttps://www.lexblog.com
3232First Qualified Regulation A Token Offering: Will “$2 Million Contribution to Crypto Industry” be Precedent Setting?https://www.lexblog.com/2019/08/04/first-qualified-regulation-a-token-offering-will-2-million-contribution-to-crypto-industry-be-precedent-setting/
Mon, 05 Aug 2019 01:51:33 +0000https://www.lexblog.com/2019/08/04/first-qualified-regulation-a-token-offering-will-2-million-contribution-to-crypto-industry-be-precedent-setting/On July 10, 2019, the Securities and Exchange Commission declared Blockstack PBC’s offering statement “qualified”, thus allowing Blockstack to commence the distribution and sale of its Stacks Tokens under Regulation A. This is the first offering of digital tokens to be qualified by the Commission under Regulation A, a significant milestone for the blockchain industry which raised billions of dollars in 2016-2018 in unregistered non-exempt initial coin offerings before the Commission threw down the gauntlet in the form of lawsuits and enforcement actions alleging illegal unregistered offerings, most recently against Kik Interactive Inc. Yet given recent Regulation A headwinds, it’s unclear to what extent other blockchain developers will follow Blockstack’s lead and look to raise capital under Regulation A.

State of Regulation A

Regulation A was reformed under the JOBS Act of 2012 to allow issuers to raise up to $50 million in any rolling 12-month period with scaled down disclosure relative to full-blown registration, freedom to test-the-waters and no qualification at the state level. Referred to as a mini-IPO, Regulation A also provides a streamlined pathway to Securities Exchange Act registration (for those issuers choosing to be SEC reporting companies) and for listing on a national securities exchange. Shares issued in a Regulation A offering are unrestricted; they can be freely resold without a holding period or other restriction.

Issuers’ and securities professionals’ hopes were high that Regulation A could be a viable alternative to registered public offerings or other existing exemptions. Initial signs were encouraging. Since Regulation A went live in 2016, over 100 transactions have been consummated averaging $10 million per deal, including ten issuers that got listed on Nasdaq or the NYSE.

Unfortunately, however, Regulation A has experienced some hiccups lately. The shares of the ten listed Regulation A issuers have fared poorly, and the Commission recently approved Nasdaq’s proposed rule to require Regulation A funded companies seeking Nasdaq listing to have a minimum two year operating history. One Regulation A issuer, Longfin Corp., terminated operations less than one year after closing its Regulation A offering and is now the subject of a fraud lawsuit by the Commission.

Blockstack Offering of Stacks Tokens

Blockstack is developing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications. Blockstack is offering up to $40 million of its Stacks Tokens, consisting of a combination of full-priced tokens to “qualified purchasers” as defined in Regulation A, discounted tokens to holders of certain purchase vouchers and non-cash consideration tokens under Blockstack’s “app mining” program in exchange for the development of well-reviewed applications on its decentralized application network. Blockstack previously raised over $50 million in VC rounds and under Rule 506(c); among those investing were big-time early stage investors Union Square Ventures, Y Combinator, Lux Capital and Naval Ravikant.

The Evolving Token

In a June 2018 speech, SEC Division of Corporate Finance Director William Hinman broke new ground when he stated that a digital asset originally sold in a securities offering could later be sold in a manner that does not constitute an offering of a security when there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created. I blogged about the speech here.

Consistent with the guidance from Hinman’s speech and with the Commission’s recent guidance in its “Framework for ‘Investment Contract’ Analysis of Digital Assets”, Blockstack asserts its Stacks Token is a security now but may not be so in the future. In its offering statement, Blockstack states that, for the foreseeable future, it anticipates treating the Stacks Token as a security based on its view that the token is an “investment contract” under the application of the Howey test to digital assets: an investment of money, in a common enterprise, with a reasonable expectation of earning a profit, through the efforts of others. With investment of money in a common enterprise and a reasonable expectation of earning a profit assumed, the real issue is whether that profit expectation is through the efforts of others.

Under the Framework and the Howey Test, a profit expectation is considered to be through the efforts of others if the network is still being developed and the token is not fully functional, because the success of the network is considered to be dependent on the efforts of management. Once the network is sufficiently decentralized, that success can no longer be said to be dependent on the efforts of management. Blockstack maintains that, currently, it employs all core developers of the Blockstack network. But as the network becomes increasingly decentralized, core developers other than those employed by Blockstack may become primarily responsible for the development and future success of the network. Blockstack also maintains it may transfer governance and control of the Blockstack network to other parties, such as network users and developers.

Whether Stacks Tokens lose their status as investment contracts will ultimately depend on whether purchasers of the tokens no longer expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack no longer retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants. Arguably, purchasers will no longer have that expectation and Blockstack will no longer have that power when the network becomes truly decentralized, at which point Blockstack asserts the Stacks Tokens will no longer constitute a security.

Precedent Setting?

Blockstack’s Regulation A journey has been an expensive and long one, purportedly costing it $2 million over the ten months of engaging in the process. Blockstack’s co-founder Muneeb Ali joked about what he calls Blockstack’s “$2 million donation to the crypto industry”, but he also made these interesting comments on his blog about the precedent setting potential of the offering:

“[the offering could] set a precedent for others in the industry...Recently, U.S. markets have been closed to crypto projects given regulatory uncertainty, and we believe in opening the U.S. markets to innovation in this area. We’ve been working with securities lawyers to create a legal framework that can enable blockchain protocols to comply with SEC regulations...Following a regulated path and proactively working with the regulators was a decision we made with the understanding that it’ll require a lot of work and time...This can potentially set a precedent for others in the industry, not just for public offerings, but also as a path to launch new public blockchains and establish a path to bootstrapping decentralized ecosystems.”

Whether Blockstack’s Regulation A offering will indeed set a capital raising precedent for others in the blockchain industry remains to be seen, and will depend on several factors including whether Regulation A can rehabilitate its brand and whether Blockstack’s “$2 million contribution to the crypto industry”, presumably through multiple versions of its offering circular and responses to voluminous SEC comment letters, will have created a practical, workable model from which others can follow Blockstack’s lead in a more cost-effective manner.

]]>SEC Exempt Offering Concept Release Seeks Comment on Ideas to Ease Restrictions on Sales to Non-Accredited Investorshttps://www.lexblog.com/2019/07/07/sec-exempt-offering-concept-release-seeks-comment-on-ideas-to-ease-restrictions-on-non-accredited-investors/
Mon, 08 Jul 2019 00:00:06 +0000https://www.lexblog.com/2019/07/07/sec-exempt-offering-concept-release-seeks-comment-on-ideas-to-ease-restrictions-on-non-accredited-investors/Non-accredited investors are estimated to constitute approximately 92% of the U.S. population. Yet restrictive rules governing exempt offerings have significantly limited their freedom to invest in private offerings and prevented or discouraged issuers from selling them privately offered securities. But in a recently issued concept release, the Securities and Exchange Commission has signaled a willingness to approach the issue in a much more creative way, suggesting the possibility of expanded opportunities for companies to include non-accredited investors in exempt offerings without unduly compromising their protection.

The SEC’s June 18, 2019 concept release seeks public comment on ways to simplify, harmonize and improve exempt offerings by removing some of the existing complexity, thereby promoting capital formation without unduly compromising investor protections and expanding opportunities for investors. In its press release issued the same day, SEC Chairman Jay Clayton noted that “input from startups, entrepreneurs and investors who have first-hand experience with [the SEC’s] exempt offering framework will be key to its efforts to analyze and improve the complex system we have today.”

Significant changes over the past few years to the rules governing exempt offerings (most notably through the Jumpstart Our Business Startups Act of 2012, the Fixing America’s Surface Transportation Act of 2015 and the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018) have resulted in a complex framework of differing requirements and conditions, which may be difficult for issuers to navigate, particularly startups and emerging companies with more limited resources.

Interestingly, the amount raised in exempt offerings has been trending higher in both absolute terms and relative to registered offerings, and now is twice the amount raised in registered public offerings. The concept release estimates that in 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion raised through exempt offerings.

Given the dominance of exempt offerings, the focus of the release is to seek input on whether the current regulatory framework provides adequate access to capital for a variety of issuers, particularly smaller issuers, and adequate access to investment opportunities for non-accredited investors while maintaining investor protections. Non-accredited investors’ primary investment opportunities have historically been in registered markets because of the restrictions on their participation in private offerings. Non-accredited investors have not had the same level of access to investment opportunities in exempt markets as an accredited investor would, and the upward trend in exempt offerings only exacerbates the problem.

Consequently, the SEC is seeking comment on whether it would be consistent with capital formation and investor protection for it to consider steps to make a broader range of investment opportunities available to non-accredited investors. In particular, the SEC is seeking comment on the following specific questions (among others):

Accredited Investor Definition. To be considered an accredited investor, an entity would need to fall under one of the designated categories of financial institutions, have more than $5 million in assets or have only accredited investor owners, while an individual must pass either a net worth or income test. The SEC is seeking comment on:

Whether the $5 million asset test for entities should be replaced with a $5 million investments test that includes all entities rather than specifically enumerated types of entities?

Whether individuals should be allowed to qualify based on other measures of sophistication, such as minimum amount of investments, certain professional credentials, experience investing in exempt offerings, knowledgeable employees of private funds for investments in their employer’s funds, individuals who pass an accredited investor examination?

Currently, a natural person just above the income or net worth thresholds would be able to invest without limits, but a person just below the thresholds cannot invest at all as an accredited investor. Should that be changed?

Rule 506 of Regulation D. Currently, Rule 506(b) allows sales to up to 35 non-accredited investors (and an unlimited number of accredited investors), but the exemption from the specific, mandated disclosure obligations of Regulation D for offerings sold only to accredited investors serves as a significant incentive to exclude non-accredited investors. Accordingly the SEC seeks comment on:

Whether it is important to continue to allow non-accredited investors to participate in Rule 506(b) offerings, and if so are the information requirements having an impact on the willingness of issuers to allow non-accredited investors to participate?

Whether the SEC should consider eliminating or scaling the information requirements depending on the characteristics of the non-accredited investors participating in the offering, such as if all non-accredited investors are advised by a financial professional or a purchaser representative?

Whether information requirements should vary if non-accredited investors can only invest a limited amount or if they invest alongside a lead accredited investor on the same terms as the lead investor?

Should non-accredited investors be allowed to purchase securities in an offering that involves general solicitation? If so, what types of investor protection conditions should apply? For example, only if: (i) such non-accredited investors had a pre-existing substantive relationship with the issuer or were not made aware of the offering through the general solicitation; (ii) the offering is done through a registered intermediary; or (iii) a minimum percentage of the offering is sold to institutional accredited investors that have experience in exempt offerings and the terms of the securities are the same as those sold to the non-accredited investors?

Regulation A. In a Tier 2 offering by an issuer of securities that are not going to be listed on a national securities exchange upon qualification, non-accredited individual investors are limited in how much they can invest to no more than 10% of the greater of their annual income or net worth, alone or together with a spouse and excluding the value of their primary residence and any loans secured by the residence (up to the value of the residence). The SEC seeks comment on:

Whether the individual investment limits for non-accredited investors in Tier 2 offerings should be changed or eliminated?

If the investment limits are changed, what limits would be appropriate?

Responses to the foregoing or any other requests for comment set forth in the concept release may be submitted to the SEC here prior to the deadline of September 24, 2019.

]]>Founder Fraud Case Study: Roundtrip Contracts and Other Revenue Recognition Schemeshttps://www.lexblog.com/2019/04/07/founder-fraud-case-study-roundtrip-contracts-and-other-revenue-recognition-schemes/
Mon, 08 Apr 2019 01:51:56 +0000https://www.lexblog.com/2019/04/07/founder-fraud-case-study-roundtrip-contracts-and-other-revenue-recognition-schemes/The Securities and Exchange Commission filed a complaint last week against the founder of venture-backed mobile payments startup Jumio, Inc., charging him with causing the company to prepare false and misleading financial statements that inflated the company’s earnings and gross margins and with defrauding secondary market purchasers of his shares. The founder, Daniel Mattes, agreed to pay more than $16 million in disgorgement and prejudgment interest plus a $640,000 penalty and to be barred from being an officer or director of a publicly traded company in the United States.

Jumio, Inc. was founded to make mobile phone purchases easier and more secure through its customer identity and credit card verification technology. The company had two lines of business: a processing business which connected merchants to payment processors in exchange for a commission paid by the processors equal to 10% of their processing fee, and a product business which licensed its ID and credit card verification technology to merchants.

Mattes appears to have engaged in separate fraudulent schemes for each of the two lines of business. As to the processing business fraud, the complaint alleges that Mattes prepared Jumio’s financials for 2013 and 2014 which overstated revenue and profitability by recording as revenue the entire amount of processing fees collected by payment processors, rather than the 10% actually paid to Jumio.

The product business fraud involved a roundtrip contract with no economic substance and improper recognition of subscription revenue. The roundtrip transaction consisted of an agreement Mattes entered into on Jumio’s behalf with a software developer under which the software developer would ostensibly pay Jumio $710,000 per quarter for credit card verification scans that the developer could resell to third parties, and Jumio would ostensibly pay the developer $800,000 per quarter for software development services. The complaint alleges that Mattes caused Jumio to recognize as revenue the $710,000 from that contract in the first quarter of 2013. Mattes apparently wasn’t careful enough in concealing this deception; the complaint asserts that he wrote to an employee not to get excited over the transaction because “it’s more a deal to get our numbers straight for the upcoming round”, evidently a reference to Jumio’s Series C offering. Although both parties ceased making payments to each other after the first quarter of 2013, Mattes had Jumio continue to record the stated revenue from that contract throughout 2013 and 2014.

The second type of product business related fraud involved recognizing as revenue at the commencement of certain subscription agreements the entire amount of subscription fees due under such agreements before services were performed, and even when it became obvious a subscriber wouldn’t pay, in clear violation of revenue recognition rules. Under Generally Accepted Accounting Principles, Jumio should have only recognized the revenue over the period of the subscription as the revenue was earned, and should not have recognized revenue from deals where collectability was not reasonably assured. Mattes’ accounting also violating SEC staff policy on revenue recognition. SEC Staff Accounting Bulletin No. 101 – Revenue Recognition in Financial Statements provides that revenue generally is realized or realizable and earned only when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the seller’s price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured.

The misstatements Mattes made in Jumio’s financial statements were material. The complaint states that Jumio’s 2013 financials represented that Jumio’s gross revenue was $101 million, when it was actually only $9.5 million; that its gross margin was $23 million, when it was actually only $9.2 million; and that its net profit was $1.3 million, when in fact it had a net loss of $10 million.

Mattes also deceived the board regarding his intentions, according to the complaint. In early 2014, Mattes set up a program to allow employees to sell shares through a broker in the secondary markets. Mattes himself had previously sold large blocks of shares to institutional investors and was under a contractual obligation to provide notice to the board (and presumably receive board consent) before selling any of his own shares. Mattes was evidently informed by a director that the board would not authorize further sales by him, apparently out of concern that he have sufficient skin in the game and be properly incentivized. When the board authorized the employee share selling program, Mattes represented to the board that he would be excluded. Nevertheless, Mattes in fact did sell his own shares through the program without notifying the board. The complaint further asserts that Mattes had been warned by company counsel that he needed board approval for the sales, and that he falsely represented to counsel that he received informal approval with ratification to follow.

Mattes’ profit from the alleged fraud was considerable, securing a profit of over $14 million from the sale of his own shares to secondary market investors through the employee selling program. His involvement in the fraud, according to the complaint, was direct. He prepared the false financials, caused them to be provided to the broker and personally discussed them with investors. He also misrepresented to at least one investor that he was not selling his own shares. When the investor noticed that funds were being wired to Mattes, Mattes falsely claimed that he was only acting as an intermediary for legal reasons on behalf of employee sellers. He was even quoted as saying to the investor that he didn’t want to sell a single share because of “lots of great stuff coming up” and that “[he]’d be stupid to sell at this point.”

In late 2014, Jumio hired a CFO, who quit after just a few days on the job. He told Jumio’s board that revenue numbers were inaccurate, referencing the roundtrip transaction in particular. The board then hired outside accountants to assess Jumio’s books, leading to a restatement of its 2013 and 2014 financial statements. But even after Mattes knew that the financial statements would need to be restated, he continued selling his stock in the secondary market.

Mattes resigned from Jumio in mid-2015 after an internal investigation. Jumio filed for Chapter 11 bankruptcy in 2016 and the shares that Mattes had sold to the secondary market purchasers became worthless. Ironically, Mattes founded Jumio in 2010 to decrease fraud (in mobile purchases). Certainly, primary culpability for the wrongdoing here lies with Mattes. But to minimize the risk of internal management fraud and avoid Jumio’s fate, companies should exercise good corporate governance and sound internal controls which appeared to be somewhat lacking at Jumio before it was too late. Among other safeguards, there should be some independent review of financial statements such as an audit committee composed of non-management directors and/or an independent accounting firm. Counsel also has an important gatekeeper role to play and should exercise diligence in protecting the interests of the company when uncovering evidence of possible fraud.

]]>Power Lyfting: Lyft IPO is Latest in Trend Giving Founders Disproportionate Voting Powerhttps://www.lexblog.com/2019/03/31/power-lyfting-lyft-ipo-is-latest-in-trend-giving-founders-disproportionate-voting-power/
Mon, 01 Apr 2019 02:34:15 +0000https://www.lexblog.com/2019/03/31/power-lyfting-lyft-ipo-is-latest-in-trend-giving-founders-disproportionate-voting-power/Lyft, Inc. last week completed its highly anticipated initial public offering, raising over $2.3 billion at a valuation of approximately $25 billion, and turning its co-founders Logan Green and John Zimmer into near billionaires on paper. But that’s not the only reason they’re smiling. Despite owning only 7% of the outstanding pre-IPO shares, Green and Zimmer will control nearly 50% of the voting power by virtue of their Class B shares having 20 votes per share and the Class A shares having just one vote per share.

Nothing that unusual so far. In three of the last four years, over one-third of the technology companies that went public featured dual-class shares, including Snap, Roku, Dropbox and Spotify. Snap went to an extreme by selling to the public shares with no voting rights at all, as did Alphabet, Under Armour and Blue Apron. I previously blogged here about Snap’s IPO of no-vote shares.

What makes Lyft’s dual class structure somewhat unusual is that it lacks a fairly typical sunset provision that would be triggered when the founders’ combined ownership falls below some threshold (often 10%) of the overall shares outstanding. In Lyft’s case, the founders’ combined ownership was already below 10% prior to the IPO. Lyft’s dual structure also has much larger disproportionality: 20 votes for every one vote held by all other stockholders, rather than the more standard 10:1. The Lyft structure will only terminate (by Class B shares converting into Class A shares) upon (I) a two-thirds vote of the Class B, (ii) the co-founders’ Class B shares representing less than 20% of the Class B outstanding, or (iii) the death or total disability of the last to die or become disabled of the co-founders.

Lyft readily concedes that its dual class structure poses a risk to investors. The first risk factor under the caption “Risks Related to Ownership of Our Class A Common Stock” in Lyft’s final offering prospectus states: “The dual class structure of our common stock has the effect of concentrating voting power with our Co-Founders, which will limit your ability to influence the outcome of important transactions, including a change in control.” It acknowledges that founders Logan and Zimmer will be able to control the vote on matters submitted to stockholders for approval, including the election of directors, amendments to the certificate of incorporation and any merger, consolidation, sale of all or substantially all assets or other major corporate transactions.

There’s an interesting debate surrounding dual class share structures, with valid arguments both for and against. Opponents assert founders shouldn’t have it both ways — access to capital markets without relinquishing control. Also, management that’s less accountable to public stockholders may pursue strategies that produce lower returns and lower value over time. Defenders contend the structure allows founders to make decisions that are in the best long term interests of the company without undue pressure from short-termist investors. Unless founders are able to control the vote through disproportionate voting shares, they may succumb to the pressure of producing quarterly results and may forego certain actions whose benefits may only accrue over the longer term like research and development and restructurings. Another argument in favor is that it neutralizes politically motivated vote initiatives such as “say on pay” or climate-change disclosures.

The New York Stock Exchange historically denied listing of companies with dual-class voting, primarily because of a general commitment to corporate democracy and accountability. But reacting to pressure from corporate boards at the height of the takeover battles of the 1980s and competition from other exchanges, the NYSE reversed course and today permits companies to go public with dual class structures.

Some opponents have advocated an outright ban on dual class structures or lobbied exchanges to refuse to list companies that have them. But the impact on IPOs must be carefully considered. Growth startups have been shying away from going public over the last 15-20 years for a variety of reasons, including regulatory burden, availability of late stage private funding and decimalization. Another reason is activist stockholder short termism, and founders may be even more reluctant to go public without the protection afforded by dual class shares, particular since other traditional defense mechanisms have fallen out of favor, including staggered boards and shareholder rights plans.

The Wall Street Journal Editorial Board, recognizing there are merits and risks associated with a dual class structure, argues that prospective Lyft investors who oppose it should simply not invest, or invest elsewhere; Uber’s IPO is rumored to be happening later this year.

A fair question to ask is whether dual-class structures, once adopted, should last forever. Research in this area indicates that the benefits of a dual-class structure for any given company decline over time, that the costs of letting management essentially entrench itself eventually outweigh the benefits of shielding the company from short-term investors. Last year, the SEC reviewed the stock market performance of companies with dual-class structures, comparing those that had time-based sunset provisions with those that allow them to last in perpetuity. It found that within two years of an IPO, companies with sunset provisions significantly outperformed those without them. Because of this and similar research conclusions, the Council of Institutional Investors has advocated in favor of time-based sunsets requiring multi-class structures with unequal voting rights to collapse to one-share, one-vote within a reasonable, specified period of not more than seven years after IPO.

Mandatory sunsets sound logical. After a certain number of years following an IPO, a company’s business model should have reached maturity such that it no longer needs protection from short termists in order to make long term changes. But here one size probably does not fit all. Companies often pivot differently in reaction to market trends and technological developments, and there’s no way to predict when companies will reach maturity. The better approach might be to give stockholders holding one vote/share stock the opportunity to vote after some period of time following an IPO as to whether or not to discontinue the dual class structure. Such a vote would ensure that founders aren’t insulated forever and would allow stockholders to determine when their company has matured to the point where the dual class structure is no longer needed or justified.

]]>Behind 2018’s Boom Year for Venture Capitalhttps://www.lexblog.com/2019/02/18/behind-2018s-boom-year-for-venture-capital/
Mon, 18 Feb 2019 14:24:39 +0000https://www.lexblog.com/2019/02/18/behind-2018s-boom-year-for-venture-capital/2018 was a historically good year for venture capital in the United States in terms of dollars invested by VC funds in U.S. companies, dollars raised by VC funds and dollar value of exits by VC-backed companies, according to the Venture Monitor for Q4 2018 published by PitchBook and the National Venture Capital Association. VC funds invested over $130 billion in over 8,000 portfolio companies in the U.S., limited partners committed $56 billion to 256 new American VC funds and 864 venture-backed exits exceeded a combined value of $120 billion. Here’s a slightly deeper dive into some of the numbers:

Record Year for VC Investments: The $130 billion invested by VC funds in U.S. companies marked the first time annual capital investment surpassed the $100 billion watermark set at the height of the dot-com boom in 2000.

Historical Year for VC Fund Capital Commitments: The $55.5 billion committed to new fund formations in 2018 was the highest amount of capital that PitchBook has ever recorded and the fifth consecutive year that at least $34 billion was raised by VC funds in the U.S.

Bigger but Fewer Funds: The median new venture fund raised $82 million, nearly triple what it was in 2014. The number of new funds, however, was below a 2016 peak.

Beginners’ Luck: Even first-time fund managers kicked butt, raising over $5 billion, the highest figure recorded in over ten years.

Early Stage Deals Surge: Early stage (Series A or B) value and count reached decade highs. Early stage median deal sizes were also higher in 2018, creating a perception that Series A is the new Series B.

But Number of Angel & Seed Deals Tanked: Although angel and seed median deal sizes increased (as was the case with the rest of VC), the number of angel and seed deals dropped by roughly half since its 2015 high.

Valuations Soaring: Median pre-money valuations more than doubled since 2013 for Series A, B, C, and D+ rounds, with the median of the latter seeing a three-fold increase.

Latest Stage Valuations Remain Fastest Growing. Median pre-money valuation of companies in Series D deals or higher shot up to $325 million, an increase of approximately 30% over 2017.

Bigger Exits, including IPOs: Total exit value surpassed $120 billion for the first time since 2012. The 85 IPOs were the most since 2014 and represented more than 50% of exit value for the second straight year.

Usual Suspects Continue Regional Dominance: No shocker, California, Massachusetts and New York continued to dominate VC investment activity, with companies in those states attracting 79% of total U.S. capital invested, although only 53 percent of completed U.S. deals.

With VC funds stockpiling massive amounts of dry powder as a result of five consecutive years of $34+ billion capital commitment hauls, VCs should be well positioned to invest in startups for the next few years, even if there’s a downturn in the VC market.

]]>In my Backyard: Real Estate Developers can Use Equity Crowdfunding both to Fund Projects and Convert Oppositionhttps://www.lexblog.com/2019/01/28/in-my-backyard-real-estate-developers-can-use-equity-crowdfunding-both-to-fund-projects-and-convert-opposition/
Mon, 28 Jan 2019 18:23:19 +0000https://www.lexblog.com/2019/01/28/in-my-backyard-real-estate-developers-can-use-equity-crowdfunding-both-to-fund-projects-and-convert-opposition/Real estate developers should seriously consider equity crowdfunding to fund development projects for two major reasons, one of which has little or nothing to do with money. The first reason is that new securities offering legislation enacted in 2012 creates new legal capital raising pathways which allow developers for the first time to use the internet to find investors, and also to raise money from non-accredited investors. The second reason is that a crowdfunding campaign can be a potent weapon in overcoming political and neighborhood opposition to a development project.

Pre-2012 Impediments to Capital Formation

Before 2012, real estate developers seeking to finance projects from private investors were faced with three major legal impediments. First, they could only accept investment from accredited investors[1], a legal designation for institutions with assets of at least $5 million or individuals meeting either an income test ($200,000 in each of the last two years, or $300,000 combined with one’s spouse) or a net worth test ($1 million without including one’s primary residence). This meant that real estate entrepreneurs were excluded from roughly 93% of the U.S. population that did not qualify as accredited investors and the $30 trillion that is estimated to be socked away in their savings accounts. Second, as if the first wasn’t limiting enough, the accredited investor had to be someone with whom the developer had a preexisting relationship. And not just any relationship; it had to be of the sort that would enable the developer to assess whether the investment was appropriate for the investor. And third, and perhaps most limiting, the developer was prohibited from engaging in any general solicitation or advertising: no ads, no mass mailings, no e-blasts and, most notably, no internet.

JOBS Act of 2012: Three Crowdfunding Alternatives

In 2012, Congress passed and President Obama signed into law the Jumpstart Our Business Startup Act, better known as the JOBS Act, a major piece of rare bipartisan legislation intended to make it easier for entrepreneurs to raise capital. In the U.S., any offering of securities must either be registered with the SEC (enormously expensive and time consuming, and triggers ongoing SEC reporting and other regulatory burdens as an SEC reporting company), or satisfy the requirements of an exemption from registration. Among other capital markets reforms, the JOBS Act created three crowdfunding exemptions from registration, divided into Titles II, III and IV, each with its own dollar limitations and other myriad rules.

Accredited Investor Crowdfunding

Title II of the JOBS Act and the SEC’s related Rule 506(c) provide for what many refer to as “accredited investor crowdfunding”. It allows developers to use the internet and other methods of general solicitation and advertising to raise an unlimited amount of capital, but with two strings attached. One, sales of securities may only be made to accredited investors. And two, the issuer must use reasonable methods to verify accredited investor status. The requirement to reasonably verify status means the old check-the-box on the one-page investor questionnaire doesn’t fly here; one would need to dig deeper and request such evidence as brokerage statements or tax returns (which investors are loathe to produce) or lawyer or accountant certifications (good luck getting those). Despite the advantage of being allowed to use the internet to reach accredited investors, however, only four percent of the capital raised in Regulation D offerings since Rule 506(c) went live in September 2013 was raised in offerings conducted pursuant to Rule 506(c), according to the SEC. It stands to reason that the culprit is the enhanced verification requirement, which is now the target for reform among capital markets reform advocates.

Non-Accredited Investor Crowdfunding

Under Title III of the JOBS Act and the SEC’s Regulation Crowdfunding, an issuer may offer and sell securities over the internet to anyone, not just accredited investors, without registering with the SEC. There are many limitations and restrictions, foremost of which is that an issuer may raise no more than $1,070,000 per year using this method. Investors in Title III deals are also capped based on their income and net worth. Issuers must sell through a third-party funding portal (only one), and there are disclosure and SEC filing requirements. Title III was the section of the JOBS Act that received the most buzz, largely because of the disruptive nature of allowing companies to raise capital from non-accredited investors, using the internet and without registering with the SEC and giving ordinary people the chance to invest in startups and other private investment opportunities they were previously shut out of, but also because of the controversy it created among those who believed that this new opportunity would be a recipe for massive fraud. To date, thankfully, there’s been virtually no fraud reported in Title III deals.

Mini-Public Offering

The third crowdfunding exemption allows companies to raise up to $50 million from the general public in a mini-public offering over the internet under Title IV of the JOBS Act and Regulation A+ promulgated by the SEC thereunder. A Regulation A+ offering is similar to a traditional registered public offering except that the disclosure statement is scaled down and the whole process far less expensive and time consuming. Regulation A+ has several distinct advantages: It generally preempts the states, meaning that issuers need only go through a review process at the Federal level with the SEC (the predecessor rule required issuers to get clearance from each state in which investors were solicited). Shares sold in a Regulation A+ offering are freely tradable and may be resold right away. And issuers may “test the waters” and gauge investor interest before committing to launch an offering. For these and other reasons, real estate developers and funds have been the most active users of Regulation A+.

Real Estate Crowdfunding

Real estate crowdfunding has rapidly grown into a multi-billion-dollar industry since the passage of the JOBS Act in 2012. It is leveling the real estate investment playing field, providing access both for ordinary individuals to an asset class they were previously shut out of, and for real estate entrepreneurs to a universe of previously forbidden but low hanging investor fruit, particularly in the form of people living in the communities where projects are being proposed for development. Through equity crowdfunding, high quality real estate investment opportunities are no longer offered strictly on a “who-you-know” basis. It replaces the hand-to-hand combat of raising capital in the old school, country club network way. What used to be multiple phone calls one investor at a time, is now a tweet that potentially reaches millions of people. With equity crowdfunding, a real estate entrepreneur can post a deal on a single portal and reach thousands of potential investors at once with the portal handling the subscription process and fund transfers electronically. Another positive aspect of real estate crowdfunding is that it has the potential to attract funding to emerging neighborhoods where traditional funding sources rarely go. Furthermore, most crowdfunding portals pool investors into a single purpose entity that acts as the investor of record, so that the pooled investors are only treated as one owner on the issuer’s cap table for accounting and corporate governance purposes.

Regulation A+ has proven to be an enormously popular capital raising pathway for diversified REIT-like real property investment vehicles because of the ability to raise up to $50 million from the general public (not just accredit investors) in a streamlined mini-public offering process and then invest those proceeds in several projects. Like conventional real estate funds, these investment vehicles generally conduct their capital raises prior to identifying specific projects. Other real estate professionals using crowdfunding are using the Rule 506(c) model, allowing them to raise an unlimited amount over the internet albeit only from accredited investors. Under this model, the real estate entrepreneur typically first identifies a project and then offers the investment to prospective investors under offering materials that describe the particular project.

Some real estate institutions have taken the crowdfunding plunge and launched crowdfunding platforms of their own, with Arbor Realty Trust/AMAC claiming to be the first institution to do so with its ArborCrowd platform. ArborCrowd markets one deal at a time and writes a check upfront, which allows a property’s sponsor to close quickly on its acquisition. ArborCrowd then offers interests in the investment vehicle through its platform to accredited investors under Rule 506(c), with minimum individual investments of $25,000. I checked on SEC’s EDGAR site and saw that ArborCrowd has done seven deals thus far, aptly named ArborCrowd Investment I-VII, respectively, which average approximately $3 million each.

Real estate funding portals come in two general varieties: those that act as matchmaking sites between real estate entrepreneurs seeking funding and investors seeking real estate investment opportunities, and others operated by real estate firms offering investment opportunities in their own proprietary deals. There are currently over 100 real estate crowdfunding platforms; some of the more established include Fundrise, RealtyMogul, CrowdStreet, Patch of Land and RealCrowd.

In My Backyard

And now we get to the more intriguing use of equity crowdfunding by real estate entrepreneurs: giving community residents skin in the game and incentivizing them to support a local development project. Most major development projects are likely to be challenged by the not-in-my-backyard phenomenon, and such opposition can derail, delay or increase project costs dramatically. Whether the project is affordable housing, a power plant or a sewage treatment facility, the developer can expect opposition from a vocal NIMBY minority, irrespective of how much the proposed project is needed by the community at large. An equity crowdfunding campaign could be a powerful tool to convert opponents and mobilize pro-project allies. One approach could be for sponsors to allocate some percentage, e.g., 10%, of a crowdfunding offering for investors residing within some given mile radius of the project. Another approach might be to conduct simultaneous offerings, one under Title III within the $1,070,000 cap with the hope of attracting local residents to invest, and a larger parallel offering to accredited investors under Rule 506(c).

Conclusion

Real estate crowdfunding is still in its nascent stages. But as awareness grows, smart reforms are implemented to improve the rules and the market matures, I believe real estate developers will embrace equity crowdfunding as both a way to fund projects that are neglected by traditional funding sources and as a strategic tool to enlist community support and overcome opposition.

[1] Technically, the most popular private offering method (Rule 506(b) of Regulation D) actually allows investment from up to 35 non-accredited investors (and an unlimited number of accredited investors). But nearly all such offerings have historically been made only to accredited investors because doing so makes the specific disclosure requirements in the Rule inapplicable.

]]>SEC Reporting Companies Now Regulation A+ Eligiblehttps://www.lexblog.com/2018/12/26/sec-reporting-companies-now-regulation-a-eligible/
Wed, 26 Dec 2018 15:37:30 +0000https://www.lexblog.com/2018/12/26/sec-reporting-companies-now-regulation-a-eligible/On December 19, 2018, the Securities and Exchange Commission issued final rules to permit reporting companies under the Securities Exchange Act to offer securities under Regulation A (affectionately referred to often as Regulation A+), as mandated by the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. The rule amendments also provide that so long as an issuer is current in its Exchange Act reporting, its periodic Regulation A reporting obligation will be deemed to be met. I previously blogged here about the SEC’s statutory mandate to make Exchange Act reporting companies Regulation A eligible. The rule amendments are effective upon publication in the Federal Register. This post will identify particular features that would make Regulation A attractive for Exchange Act reporting companies.

The amendments will likely impact U.S. and Canadian reporting companies seeking to conduct public offerings within the Regulation A offering limit of $50 million, particularly offerings of non-exchange-listed-securities. That’s because blue sky preemption is available for Tier 2 of Regulation A, but is generally not available for non-exchange-listed securities sold in registered offerings. During 2017, there were approximately 584 reporting companies with registered securities offerings of up to $50 million that would now be eligible for Regulation A, including approximately 267 offerings of non-exchange-listed securities.

The amendments may also benefit previous Regulation A issuers that became Exchange Act reporting companies and that may seek to engage in follow-on Regulation A offerings.

Exchange Act reporting companies may also be attracted to Regulation A’s more flexible “test-the-waters” communication rules for soliciting investor interest as compared with registered offerings. Although companies qualifying as “emerging growth companies” are also permitted to test the waters in registered offerings, such solicitations are limited to qualified institutional buyers and institutional accredited investors and exclude individuals. Regulation A’s test-the-water rules permit issuers to solicit all prospective investors, including individuals, and without a requirement to file test-the-waters materials (as is the case with registered offerings).

Regulation A also contains a safe harbor from integration of Regulation A offerings with prior offers or sales of securities, as well as with subsequent offers or sales of securities registered under the Securities Act. The flexibility to alternate between Regulation A and registered offerings may be particularly valuable for Exchange Act reporting companies, particularly those that are uncertain about whether their future funding strategy will rely on Regulation A or registered offerings.

Finally, the conditional exemption for Tier 2 securities from the shareholders of record threshold for Section 12(g) registration purposes would be attractive for Exchange Act reporting issuers because maintaining a lower number of shareholders of record would make it easier to deregister and suspend Exchange Act reporting in the future.

On the flip side, one disadvantage worth noting is that Regulation A does not permit at-the-market offerings, which may limit the attractiveness of Regulation A for some Exchange Act reporting companies seeking the flexibility of at-the-market offerings.

]]>First Federal Ruling Against SEC on Whether Digital Token is a Securityhttps://www.lexblog.com/2018/12/02/first-federal-ruling-against-sec-on-whether-digital-token-is-a-security/
Mon, 03 Dec 2018 03:05:31 +0000https://www.lexblog.com/2018/12/02/first-federal-ruling-against-sec-on-whether-digital-token-is-a-security/On November 27, 2018, the United States District Court for the Southern District of California denied the Securities and Exchange Commission’s motion for a preliminary injunction to block an initial coin offering, finding the Commission did not meet its burden of showing the digital token in question was a security. Although this appears to be the first Federal decision against the Commission on the question of whether a token is a security under the Howey test, and may encourage some issuers with the resources to do so to resist SEC enforcement efforts, the order is extremely narrow in scope and is not likely to deter the Commission’s ICO enforcement efforts or shed much light on when if ever a token is not a security.

The issuer in this case, Blockvest LLC, is purportedly seeking to develop the “first licensed and regulated tokenized crypto currency exchange and index fund based in the U.S.” Earlier this year, it announced a plan to issue tokens in three stages: a private sale with a 50% bonus, followed by a “pre-sale” with a 20% bonus, and then a $100 million ICO to be launched on December 1, 2018.

In its original complaint filed on October 3, the Commission premised its fraud case on the notion that Blockvest’s token was a security without analyzing the facts under Howey, but rather by asserting that Blockvest itself conceded that its BLV token was a security by filing a Form D with the Commission and stating on its website that it was “Regulation A+ compliant and can offer [its] securities offering to Unaccredited Investors all over the globe” (emphasis added). See my last blog post regarding the Blockvest offering and its apparent offering exemption confusion.

In mid-October, U.S. District Judge Gonzalo Curiel, issued an ex parte (i.e., with only the Commission appearing before him) temporary restraining order in this case freezing Blockvest’s assets related to the ICO, based solely on the Commission’s version of the facts and largely because of multiple false claims made by Blockvest in its ICO promotional materials that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte.

As to the issue of whether Blockvest’s BLV token was a security, because the earlier TRO motion was made ex parte, the Court based its factual findings at that procedural stage entirely on what the Commission had asserted, namely that investors had invested more than $2.5 million in BLV tokens, which constituted 18% of the offering, and that the purchasers were interested primarily in the profit the BLVs were expected to generate given that Blockvest’s website promised that the BLVs would generate passive income.

But in Blockvest’s brief opposing the preliminary injunction motion and in a related written declaration by its founder Buddy Ringgold, the defendants offered a completely different factual narrative. They asserted that in fact no tokens were sold to the public and that Blockvest never received any money from their sale, and that Blockvest had only one investor (Rosegold Investment, in which Ringgold himself and friends and family were investors). Further, they asserted that BLV tokens were only used to test the platform by 32 “testers” who contributed less than $10,000 in the aggregate. The BLV tokens were never released to the testers and the testers could not remove the tokens from the platform. Presumably, the testers could not resell them for profit.

The injunction rejection order states that “Ringgold recognizes that mistakes were made” but does not specify what those were. Presumably, it’s a reference to the various misrepresentations about regulatory endorsement. It may also refer to allowing eight of 17 investors in Rosegold (the investment vehicle) to write “Blockvest” and/or “coins” on their checks. It may also be a reference to Blockvest’s website temporarily featuring a credit card function with a “buy now” button. As to the SEC’s allegation that Blockvest had raised $2.5 million from investors, as Blockvest had boasted on social media, Blockvest explained it away as an “overly optimistic” statement and that in any event the funds were not intended to come from the public but rather from one investor, David Drake, and had fallen through anyway. Ringgold maintains the mistakes were made in the early stages of development when Blockvest’s chief compliance officer had not yet reviewed all the materials.

Unlike the TRO order, the injunction rejection order does invoke the Howey test, under which an instrument is deemed to be an investment contract and thus a security if it involves (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of earning a profit through the efforts of others. Judge Curiel addressed the first and third prongs of Howey, but not the second. Under the first prong, “investment of money”, Judge Curiel examined not what the testers’ intent was in committing funds, but rather what Blockvest represented to the testers and what the testers relied on. Here, Judge Curiel found that the Commission and Blockvest provided “starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral representations at the seminars, before they purchased the test BLV tokens”, and that consequently the court could not make a determination as to whether the test BLV tokens were “securities” under the first prong of Howey. As to the second prong, “expectation of profits”, which Judge Curiel identified as either through capital appreciation or profit participation, he once again found that the Commission had not met its burden of proving expectation of profit.

So what are the key takeaways here? The competing factual narratives suggest this to be a narrow ruling. It must be kept in mind that this order comes without the benefit of full discovery; it’s basically “he said/she said”. And without full discovery to address disputed issues of material facts, the court could not conclude that the Commission had met its burden in establishing that the BLV token offered to the 32 test investors was a security. Also, the Commission may have brought this case prematurely inasmuch as it was under the impression that the tokens had already been sold to the public; Blockvest in turn asserted facts indicating that no tokens had yet been issued (or offered) to the public and the tokens purchased by the testers were for testing purposes only and never released from the platform. It’s also unclear whether the Commission will pursue this case inasmuch as it has already secured Blockvest’s commitment to cease all efforts with respect to the ICO and to give the Commission 30 days’ notice of any resumption of efforts in this regard. Nevertheless, the order does serve as a reminder that the Commission, when seeking enforcement against an ICO in court, will have the burden of establishing that each of Howey’s prongs have been met, and suggests that future cases may be decided on the issuer’s actual marketing efforts and representations to purchasers and not on subjective perceptions of those purchasers’ expectations of profit.

]]>Imitation Not Always Flattery: SEC Halts ICO that Falsely Claimed Approval by SEC and Self-Created “Blockchain Exchange Commission”https://www.lexblog.com/2018/10/14/imitation-not-always-flattery-ico-falsely-claims-approval-of-sec-and-self-created-blockchain-exchange-commission/
Sun, 14 Oct 2018 19:04:49 +0000https://www.lexblog.com/2018/10/14/imitation-not-always-flattery-ico-falsely-claims-approval-of-sec-and-self-created-blockchain-exchange-commission/If you were looking for a safe blockchain investment and had the chance to invest in the “first licensed and regulated tokenized cryptocurrency exchange and index fund based in the U.S.” and audited by a Big 4 accounting firm, you might do it, right? One problem: turns out it’s not licensed, regulated or audited.

On October 11, 2018, the Securities and Exchange Commission announced it had obtained an emergency court order halting Blockvest, LLC’s initial coin offering, whose sponsors falsely claimed that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte. None of that was true. The sponsors claimed they had already raised more than $2.5 million in pre-ICO sales of its digital token, BLV, and that it sought to raise an aggregate of $100 million in the ICO. The order also halts ongoing pre-ICO sales by Blockvest and its founder, Reginald Buddy Ringgold, III, a/k/a Rasool Abdul Rahim El.

The most brazen aspect of the alleged fraudulent scheme was the sponsors’ apparent creation of a fictitious blockchain regulatory agency which they call the “Blockchain Exchange Commission” or “BEC”, which they claim “regulates the blockchain digital asset space to protect digital asset investors”. In May 2018, roughly one month after filing a Form D for the BLV offering (see below), Ringgold created the BEC, renaming a company that had been previously incorporated under various names including “Fartlife.” The BEC seems to plagiarize the SEC’s logo and mission statement, and gives itself the same address as SEC headquarters (100 F Street, NE, Washington, DC). The BEC’s LinkedIn page includes a logo nearly identical to the SEC’s logo (see left), as well as the following mission statement, also uncannily similar to the SEC’s:

“The mission of the BEC is to protect investors; and assist in maintaining fair, orderly, and efficient markets within the Blockchain Digital Asset Space...The Blockchain Exchange Commission, or BEC, is dedicated to investor protection and market integrity.”

Blockvest also appears to be confused about securities offering rules. It filed a Form D with the SEC on April 16, 2018, claiming an exemption under Rule 506(c), which requires that all purchasers be accredited investors and that the issuer use reasonable methods to verify status. The SEC’s complaint states that, on information and belief, Blockvest has not taken reasonable steps to ensure that BLV investors are accredited. Also, despite their Form D, Blockvest’s website invokes Regulation A. Never mind that Regulation A has an offering limit of $50 million (Blockvest is seeking $100 million in its ICO), and prohibits any sales until the issuer has filed an offering statement on Form 1-A and the SEC has issued a notice of qualification. The SEC’s complaint further states that Blockvest’s website stated falsely that its ICO was “Reg A+ compliant” and can offer its securities to unaccredited investors all over the globe. Blockvest’s website now states that the “Pre-IPO testing the waters phase has been halted.” Testing the waters is a Regulation A concept. Blockvest hasn’t filed a Form 1-A offering statement, nor has any offering been qualified by the SEC under Regulation A.

The SEC complaint should serve as a warning to issuers conducting unregistered ICOs to exercise caution and avoid language implying that that their tokens have been registered with the SEC, or that the SEC has passed on the merits of the offered tokens. This is why exempt offerings include the following legend in their disclosure documents:

THE SECURITIES OFFERED HEREBY HAVE NOT BEEN APPROVED BY THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION, OR ANY STATE SECURITY AUTHORITY. ANY REPRESENTATION TO THE CONTRARY IS UNLAWFUL.

THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION DOES NOT PASS UPON THE MERITS OF OR GIVE ITS APPROVAL TO ANY SECURITIES OFFERED OR THE TERMS OF THE OFFERING, NOR DOES IT PASS UPON THE ACCURACY OR COMPLETENESS OF ANY OFFERING CIRCULAR OR OTHER SOLICITATION MATERIALS. THESE SECURITIES ARE OFFERED PURSUANT TO AN EXEMPTION FROM REGISTRATION WITH THE COMMISSION; HOWEVER, THE COMMISSION HAS NOT MADE AN INDEPENDENT DETERMINATION THAT THE SECURITIES OFFERED HEREUNDER ARE EXEMPT FROM REGISTRATION.

]]>Gig Stock: Extension of Rule 701 Exemption for Compensatory Equity Proposed for Gig Economy Participantshttps://www.lexblog.com/2018/09/25/gig-stock-extension-of-rule-701-exemption-for-compensatory-equity-proposed-for-gig-economy-participants/
Tue, 25 Sep 2018 23:01:46 +0000https://www.lexblog.com/2018/09/25/gig-stock-extension-of-rule-701-exemption-for-compensatory-equity-proposed-for-gig-economy-participants/Private companies in the gig economy like Uber and Airbnb would love to issue compensatory equity to their platform participants, just like they’re able to do with their employees. The problem is that the exemption from registration for compensatory issuances only covers issuances to employees and consultants of the issuer. Last July, however, the Securities and Exchange Commission published a concept release seeking comment on whether the exemption should be extended to equity issued to participants in the gig economy. This past Friday, Airbnb delivered a comment letter to the Commission advocating for an expansion of the exemption to cover sharing economy participants. This blog post will seek to explain some of the key issues involved here.

Background: Rule 701

Rule 701 of the Securities Act of 1933 provides a safe harbor exemption from registration for equity securities issued as compensation by non-reporting companies to employees, consultants, advisors or de facto employees providing services to the issuer. The purpose of the exemption is to facilitate securities-based compensation; it’s not available for capital-raising issuances or any other issuances for any purpose other than equity compensation.

The aggregate sales price or amount of securities that may be sold during any rolling 12-month period must not exceed the greatest of (i) 15% of the issuer’s total assets, (ii) 15% of the outstanding amount of the class of securities being offered and sold under Rule 701, or (iii) $1 million.

The issuer must give all participants a copy of the benefit plan or contract setting forth the incentive equity. Beyond that, if the aggregate sales price or amount of securities sold under Rule 701 during any rolling 12-month period exceeds $10 million, the issuer must also provide additional mandated disclosure, including risk factors and specified financial statements.

Finally, under the amendments to Section 12(g) of the Securities Exchange Act of 1934 introduced by the JOBS Act (which increased the shareholder thresholds at which issuers must register a class of securities under the Exchange Act to 2,000 or 500 non-accredited investors), persons holding only securities received under an employee compensation plan in a transaction exempt from registration (including under Rule 701) are not considered to be holders of record for calculating record holders under Section 12(g).

Concept Release on Compensatory Securities Offerings and Sale

The Securities and Exchange Commission published its Concept Release on Compensatory Securities Offerings and Sales on July 18, 2018. In the introductory sections of the concept release, the Commission described the characteristics of the gig economy where service providers use a company’s Internet platform for a fee to provide peer-to-peer services such as ride-sharing, food delivery, household repairs, dog-sitting, tech support and lodging. These are not traditional employment relationships, and so the participants aren’t deemed to be “employees” — or consultants, advisors or de facto employees – and thus are ineligible to receive securities in compensatory arrangements under Rule 701. But the same compensatory and incentive motivations to include equity in employee compensation may exist with respect to gig economy participants, i.e., alignment of interests, recruitment, retention and enhanced compensation relative to what a company may be able to pay in cash or other benefits.

Accordingly, in light of the significant evolution in the composition of the workforce since Rule 701’s last meaningful amendment 20 years ago, the concept release sought comment on possible ways to modernize the exemption and expand it to cover securities issued to participants in the gig economy. In seeking comment from the public to determine what attributes of gig economy relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption, the Commission posed several specific questions, including the following:

What activities should an individual need to engage in to be eligible?

Should the test identify Rule 701 eligible participants as individuals who use the issuer’s platform to secure work providing lawful services to end users?

Should there be a sufficient nexus between the individual and the issuer to justify application of the exemption for compensatory transactions?

Should it matter whether individuals provide services to the issuer, or instead to the issuer’s customers or end users?

Does it matter whether that business activity provides a service typically provided by an employee or is more of an entrepreneurial nature?

Whether a potential eligibility test should consider the individual’s level of dependence on the issuer, or, conversely, the issuer’s degree of dependence on the individuals?

Should it matter what percentage of the individual’s earned income is derived from using the issuer’s platform?

Recognizing that extending eligibility to individuals participating in the gig economy could significantly increase the volume of Rule 701 issuances, the Commission posed these additional questions:

Would revising the rule have an effect on a company’s decision to become a reporting company?

Would such revisions encourage companies to stay private longer?

To what extent do companies utilizing “gig economy” workers issue securities as compensation to those individuals?

What effect would the use of Rule 701 for “gig economy” companies have on competition among those companies and newer companies and more established companies vying for the same talent?

Should a gig economy participant receive the same disclosure as an employee?

The Airbnb Comment Letter

In a letter dated September 21, 2018, Airbnb responded to the concept release and offered a convincing rationale for reforming Rule 701 as well as several interesting specific proposals.

As to rationale, Arbnb’s comment letter argues that expanding the category of persons eligible to receive securities under the Rule is consistent with the goals of the JOBS Act to facilitate entrepreneurship and growth startups. Doing so would further democratize share ownership and enable many ordinary individuals who have been effectively excluded from early stage investing to benefit from the potential growth of startups. It would align the interests of sharing economy companies with the service providers who use their platforms to the benefit of both. (Note that Airbnb is careful to use the term “sharing economy” rather than “gig economy”; for a good, concise explanation of the distinction, see here.) Extending the exemption to issuances to sharing economy participants would also incentivize individuals to leverage their assets to participate in the sharing economy and supplement their income. Finally, it would help younger and smaller companies compete with older and larger competitors yielding better outcomes for end users.

Because of the magnitude of Airbnb’s and other sharing economy companies’ participants, Airbnb asserts that the extension of Rule 701 to sharing economy participants would only be useful to those companies if they were allowed to exclude the recipients from the number of record holders under Section 12(g), as is the case with recipients under the current Rule; otherwise, such issuers would easily exceed either or both the 2,000 holder or 500 non-accredited investor holder threshold forcing those companies to register with the Commission and be saddled prematurely with its regulatory and reporting regime.

But shouldn’t sharing economy participants receive adequate disclosure when receiving securities? Airbnb asserts that most Rule 701 recipients are not making an investment decision when they receive their shares (which is why there’s no mandated disclosure obligation under the current Rule unless a dollar threshold is exceeded). Moreover, sharing economy participants would be expected to know much more about the issuer than typical investors, thus minimizing the need for disclosure. Finally, the primary motivation for issuing equity to participants would not be to raise capital but rather to align interests.

Airbnb advocates for the creation of a new subcategory of eligible recipients under Rule 701, which would be more restrictive than for recipients under the current Rule. The focus of any amendment to Rule 701 to create what Airbnb calls the Sharing Economy Award Exemption should be on the nature of eligible companies, nature of securities awarded to participants and transferability of the securities.

Eligible companies would need to satisfy the following criteria to ensure they are bona fide sharing economy companies and not just seeking to sell securities:

Provide a platform to allow third parties to provide goods and/or services to end users;

Derive a significant portion of its revenue from fees paid by platform participants;

Control the platform by either having the right to exclude a listing or participant for violating terms, or by determining amount of user fees and terms and conditions for receiving payment for goods and services sold on the platform.

Airbnb believes the securities permissible under the Sharing Economy Award Exemption should be more limited than currently allowed. Recipients should not be permitted to choose between securities or cash, so that they aren’t making an investment decision. Not more than 50% of the value received by the recipient from the issuer for goods and services sold on the platform over a 24 month period should be in the form of equity. And any equity award should not be made contingent on making a capital contribution, to ensure the absence of a capital raising motive.

Finally, Airbnb believes the restrictions on transferability of securities issued in the Sharing Economy Award Exemption should be more restrictive than under current Rule 701, even suggesting that it would be appropriate to provide that such securities be non-transferable prior to an IPO or a change in control. If such serious transfer restrictions are imposed and no cash is contributed in connection with the issuance, Airbnb believes any disclosure obligation should be minimal.

]]>“No Good Deed”: Free Tokens Issued in Airdrops, Bounty Programs Likely Violate Securities Lawshttps://www.lexblog.com/2018/08/19/no-good-deed-free-tokens-issued-in-airdrops-bounty-programs-likely-violate-securities-laws/
Sun, 19 Aug 2018 21:40:01 +0000https://www.lexblog.com/2018/08/19/no-good-deed-free-tokens-issued-in-airdrops-bounty-programs-likely-violate-securities-laws/If you’re thinking of airdropping free tokens or implementing a cryptocurrency bounty program, be careful. The Securities and Exchange Commission just issued a cease and desist order (the “Order”) with respect to an initial coin offering, finding the issuance of “free” tokens through a related bounty program in exchange for online promotional services constituted an unregistered sale of securities and thus a violation of the registration provisions of the federal securities laws. Although courts and the Commission have traditionally held that the transfer of “free” shares of stock is a “sale” of securities where the issuer derives some benefit from the transfer, the Order is the first treatment of the issue in the context of cryptocurrency bounty programs.

Airdrops and Bounty Programs

An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. The main goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Like airdrops, bounty progrms are a means of advertising and have become a useful part of many ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as marketing and making improvements to aspects of the cryptocurrency framework. Airdrops and bounties are similar in that both involve issuing seemingly free tokens. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements. But in a bounty program, individuals must execute assigned tasks before receiving the tokens.

The Facts

According to the Order, Tomahawk Exploration LLC and its founder attempted to raise money through the sale of blockchain-based digital tokens called “Tomahawkcoins” or TOM to fund oil exploration in California. Although Tomahawk failed to raise money through the ICO, it issued approximately 80,000 TOM to approximately 40 wallet holders on a decentralized platform as part of a bounty program in exchange for online promotional and marketing services to promote the ICO. Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 TOM for activities such as making requests to list TOM on token trading platforms, promoting TOM on blogs and other online forums like Twitter or Facebook, and creating professional picture file designs, YouTube videos or other promotional materials.

Legal Background

Section 5 of the Securities Act of 1933 makes it unlawful to offer or sell any security unless a registration statement is in effect as to that security or there is an available exemption from registration. The terms “offer” and “sale” are defined very broadly in the Securities Act. Section 2(a)(3) of the Securities Act defines an “offer” of securities as any “attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value”. Similarly, Section 2(a)(3) defines a “sale” of securities” under Section 2(a)(3) of the Securities Act as “every disposition of a security or interest in a security, for value.”

The Order

The Order found that the bounty program constituted an offer of securities under Section 2(a)(3) of the Securities Act because it involved an offer to dispose of a security for value. The Order states that the lack of monetary consideration for the shares doesn’t mean there wasn’t a sale or offer for sale for purposes of Section 5, asserting that a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit. According to the Order, the value or real benefit that Tomahawk received in exchange for the token distributions under the bounty program was in the form of promotion of the ICO on blogs and other online forums and in the creation of a public trading market for its securities. The decentralized platform on which Tomahawk issued the TOM tokens was publicly accessible to U.S. persons and others throughout the offering period, and bounty recipients subsequently traded their TOM tokens on a platform for digital assets.

Bounty program and airdrop enthusiasts would probably point to the Howey test, identified by the Commission as the relevant standard for determining whether a token is an investment contract and thus a security, to support the proposition that tokens issued in airdrops and bounty programs should not be securities. Howey states that for an instrument to be a security, there must be an investment of “money” (in a common enterprise with a reasonable expectation of earning a profit through the efforts of others); since no money is exchanged, the argument is that there is no security. But the Order makes it clear that the Commission continues to interpret the Howey test’s reference to “money” very broadly. That interpretation was made clear in the 2017 DAO Report:

“In determining whether an investment contract exists, the investment of “money” need not take the form of cash. See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (“[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”).

Possible Exemption: Rule 701

Just because a token is deemed to be a “security” or its issuance a “sale” of securities doesn’t mean it’s illegal. It just means the issuer needs either to register the offering with the SEC (not happening) or satisfy the requirements for an exemption from registration. One possible exemption that token issuers should consider when pondering a bounty program is Rule 701, which is the primary exemption used by non-reporting companies to issue equity incentive awards without registration to employees and certain consultants. There are three key elements here. First, the issuer would need to have a written instrument evidencing the recipients’ right to receive tokens as compensation for services. Second, the bounty program cannot be related to raising money, so the announcement regarding the bounty program should promote the product or service as opposed to fundraising. Finally, the recipients of the tokens in the bounty program may not be engaged in any securities promotion on behalf of the issuer.

]]>“Third Time’s a Charm”: House Adopts JOBS Act 3.0 to Fix Earlier Capital Raising Reform Effortshttps://www.lexblog.com/2018/07/23/threes-a-charm-house-adopts-jobs-act-3-0-to-fix-earlier-capital-raising-reform-efforts/
Tue, 24 Jul 2018 00:35:51 +0000https://lexblognetwork.wpengine.com/2018/07/23/threes-a-charm-house-adopts-jobs-act-3-0-to-fix-earlier-capital-raising-reform-efforts/It’s not often that the House of Representatives votes nearly unanimously on anything noteworthy these days, but that’s exactly what the House did on July 17 in voting 406-4 for the “JOBS and Investor Confidence Act of 2018”, also known on the street as “JOBS Act 3.0”, which is the latest iteration of the effort to improve on the capital markets reform initiative started in the original JOBS Act of 2012. JOBS Act 3.0 consists of 32 individual pieces of legislation that have passed the Financial Services Committee or the House, the substance of several of which I have blogged about previously. If passed by the Senate in some form or another and signed by the President, the reforms included in JOBS Act 3.0 will continue the process of removing unreasonable impediments to capital formation by early stage companies and address perceived problems with the original JOBS Act.

The highlights of JOBS Act 3.0 passed by the House are as follows:

Demo Days: Helping Angels Lead Our Startups Act” or the “HALOS Act”

The bill would direct the SEC to amend Regulation D to make clear that activities associated with demo day or pitch night events satisfying certain criteria would not constitute prohibited “general solicitation” under Regulation D. Specifically, the new exemption would cover events with specified types of sponsors, such as “angel investor groups”, venture forums and venture capital associations, so long as the event advertising doesn’t refer to any specific offering of securities by the issuer, the sponsor doesn’t provide investment advice to attendees or engage in investment negotiations with attendees, charge certain fees, or receive certain compensation, and no specific information regarding a securities offering is communicated at the event beyond the type and amount of securities being offered, the amount of securities already subscribed for and the intended use of proceeds from the offering.

I previously blogged about the issue of demo days and the ban on general solicitation here.

Private Company M&A Brokers: Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017

The bill would exempt from SEC broker-dealer registration mergers-and-acquisitions brokers that facilitate transfers of ownership in privately held companies with earnings or revenues under a specified threshold. The exemption would not apply to any broker who takes custody of funds or securities, participates in a public offering of registered securities, engages in a transaction involving certain shell companies, provides or facilitates financing related to the transfer of ownership, represents both buyer and seller without disclosure and consent, assists in the formation of a group of buyers, engages in transferring ownership to a passive buyer, binds a party to a transfer of ownership or is a “bad actor”.

Since 2014, private company M&A brokers could at best be guided by an SEC no-action letter, although there had been previous Congressional efforts to codify the protection, which I had blogged about here.

The bill would direct the SEC to expand the definition of “accredited investor” under Regulation D beyond the net worth and income test to include individuals licensed as a broker or investment advisor and individuals determined by the SEC to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment.

Venture Exchanges: Main Street Growth Act

Although the JOBS Act created an IPO on-ramp for emerging growth companies, it did comparatively little to address secondary market trading in these companies. This portion of the bill seeks to remedy that shortcoming by providing a tailored trading platform for EGCs and stocks with distressed liquidity. Companies that choose to list on a venture exchange would have their shares traded on a single venue, thereby concentrating liquidity and exempting their shares from rules that are more appropriate for deeply liquid and highly valued stocks. Venture exchanges would also be afforded the flexibility to develop appropriate “tick sizes” that could help incentivize market makers to trade in the shares of companies listed on the exchange.

Dodd-Frank requires private equity and hedge fund managers to register with the SEC under the Investment Advisors Act but allows venture capital fund managers to become “exempt reporting advisors” and be relieved from the regulatory requirements encountered by registered investment advisors. Currently, to qualify under the venture capital fund definition and register with the SEC as an exempt reporting advisor, VCs must ensure that more than 80% of their activities are in qualifying investments, which are defined only as direct investments in private companies.

The bill would require the SEC to revise the definitions of a qualifying portfolio company and a qualifying investment to include an emerging growth company and the equity securities of an emerging growth company, “whether acquired directly from the company or in a secondary acquisition”, for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act. A company qualifies as an emerging growth company if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and continues to be an emerging growth company for the first five fiscal years after it completes an IPO unless its total annual gross revenues are $1.07 billion or more, it has issued more than $1 billion in non-convertible debt in the past three years or it becomes a “large accelerated filer”.

Founders often leave startups, voluntarily or involuntarily, and it may be in everyone’s interest to have their shares purchased by other existing shareholders rather than sold to an outsider or held by a disgruntled founder. VC funds should have the flexibility to be able to buy those shares. Similarly, the inclusion of emerging growth companies in the category of qualifying portfolio company will benefit the innovation ecosystem by encouraging VC funds to invest further in their portfolio companies post-IPO.

Special Purpose Crowdfunding Vehicles: Crowdfunding Amendments Act

One of the perceived defects of the rules governing equity crowdfunding under Regulation CF is the ineligibility of investment vehicles. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors under Regulation D to invest in a special purpose vehicle whose only purpose is to invest in an operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules. Due to the fear of having to collect thousands of signatures every time shareholder consent is required for a transaction, higher-quality issuers with other financing options are less likely to crowdfund without a single-purpose-vehicle. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

The bill would allow equity crowdfunding offerings under Reg CF through special purpose vehicles that issue only one class of securities, receive no compensation in connection with the offering and are advised by a registered investment adviser. Special-purpose-vehicles allow small investors to invest alongside a sophisticated lead investor with a fiduciary duty to advocate for their interests. The lead investor may negotiate better terms and represent small investors on the board. Retail investors don’t enjoy these benefits under Reg CF.

]]>SEC Expands Eligibility for Scaled Disclosure; Signals Possible Auditor Attestation Reliefhttps://www.lexblog.com/2018/07/15/sec-expands-eligibility-for-scaled-disclosure-signals-possible-auditor-attestation-relief/
Mon, 16 Jul 2018 01:13:45 +0000https://lexblognetwork.wpengine.com/2018/07/15/sec-expands-eligibility-for-scaled-disclosure-signals-possible-auditor-attestation-relief/On June 28, 2018, the Securities and Exchange Commission issued a release amending the definition of “smaller reporting company” (“SRC”) to expand the number of reporting companies eligible for relaxed or scaled disclosure. The change is estimated to benefit nearly 1,000 additional small public companies currently outside the SRC definition. But equally noteworthy in the SRC release is that the Commission staff has been directed, and has begun, to formulate recommendations to the Commission for possible changes to another definition, that of “accelerated filer”, to reduce the number of companies that qualify as accelerated filers in order to further reduce compliance costs. That change would likely be more significant than expanding the SRC definition because “accelerated filer” status triggers the expensive requirement to obtain auditor attestation for management’s assessment of internal control over financial reporting.

Background

Smaller Reporting Company

The Commission established the SRC category in 2008 in an effort to provide general regulatory relief for smaller companies. SRCs are allowed to provide scaled disclosures under Regulation S-K and Regulation S-X. Under the previous SRC definition, SRCs generally were companies with less than $75 million in public float (i.e., aggregate market capitalization of a company’s shares held by non-affiliates). Companies with no public float − because they have no public equity outstanding or no market price for their public equity − were considered SRCs if they had less than $50 million in annual revenues.

Examples of scaled disclosure available to SRCs are two year management discussion and analysis comparisons rather than three years, no compensation discussion and analysis and no risk factor disclosure in Exchange Act filings. A table summarizing the scaled disclosure accommodations for SRCs can be found in the Annex at the bottom of this post.

Under previous rules, SRCs were also automatically excluded from being categorized as “accelerated filers” or “large accelerated filers”, the requirements of which are discussed below. As a result, existing public float thresholds in the accelerated filer definition aligned with the public float threshold in the SRC definition.

Accelerated Filer

In December 2005, the SEC voted to adopt amendments that redefined “accelerated filers” as companies that have at least $75 million, but less than $700 million, in public float, and created a new category of “large accelerated filers” that includes companies with a public float of $700 million or more. In addition to the requirement to file periodic reports on an accelerated basis, accelerated filers must also have their auditor provide an attestation report on management’s assessment of internal control over financial reporting under Section 404(b) of Sarbanes-Oxley.

The determinations of public float thresholds for SRC and accelerated filer status are both made as of the last business day of a registrant’s most recently completed second fiscal quarter for purposes of the following fiscal year.

Amendments to Smaller Reporting Company and Accelerated Filer Definitions

The new rules define SRCs as companies with less than $250 million of public float, as compared with the $75 million threshold under the previous definition. The final rules also expand the definition to include companies with less than $100 million in annual revenues if they have either no public float or a public float of less than $700 million. This reflects a change from the revenue test in the prior definition, under which a company would be categorized as an SRC only if it had no public float and less than $50 million in annual revenues.

The final rules will become effective September 10, 2018.

The amended SRC thresholds are summarized in the following chart:

Criterion

Current Definition

Revised Definition

Public Float

Public float of less than $75 million

Public float of less than $250 million

Revenue

Less than $50 million of annual revenue and no public float

Less than $100 million of annual revenues and:

no public float, or

public float of less than $700 million

The increase in SRC public float thresholds will lead to a dramatic expansion in companies eligible for scaled disclosure. The Commission estimates that 966 additional registrants will be eligible for SRC status in the first year under the new definition. These registrants estimated to be eligible in the first year comprise 779 registrants with a public float of $75 million or more and less than $250 million, 26 registrants with no public float and revenues of $50 million or more and less than $100 million, and 161 registrants with revenues below $100 million and a public float of $250 million or more and less than $700 million.

The SRC amendments also eliminate the automatic exclusion of SRCs from accelerated filer status. The definitions of accelerated filer and large accelerated filer are based on public float, but previously contained a provision excluding SRCs from accelerated filer status. As a result, raising the SRC public float threshold without eliminating that provision effectively would raise the accelerated filer public float threshold as well.

Accordingly, the Commission had also considered increasing the public float thresholds in the accelerated filer definition, consistent with the changes to the SRC definition, to reduce compliance costs and maintain uniformity across relevant rules. Opponents viewed a parallel increase in the accelerated filer thresholds as a weakening of investor protections. Some cited a 2011 Staff Section 404(b) Study finding that accelerated filers subject to Section 404(b)’s attestation requirement had a lower restatement rate compared to non-accelerated filers not subject to Section 404(b). But supporters argued that the attestation requirement is particularly costly for SRCs and that audit costs associated with Section 404(b) divert capital from core business needs. One maintained that a Section 404(b) audit represents over $1 million of capital diversion. Another cited the same 2011 Staff Section 404(b) Study which estimated that companies with a public float between $75 million and $250 million spend, on average, $840,276 to comply with Section 404(b). Interestingly, one commenter that stated that its public float was more than $75 million but less than $250 million estimated that relief from Section 404(b) would result in a 35% reduction in compliance costs whereas there would be no material change in such costs from the SRC amendments qualifying him for scaled disclosure as an SRC.

In the final rules release, the Commission determined to eliminate the exclusion of SRCs from accelerated filer status, effectively deciding not to increase the accelerated filer thresholds.

As indicated in the chart below, the increase in the SRC thresholds coupled with the elimination of the automatic exclusion of SRCs from accelerated filer status (i.e., no increase in the accelerated filer threshold) means good news/bad news for companies with a public float between $75 million and $250 million: they benefit from scaled disclosure (unlike under previous rules), but must continue to provide auditor attestations to management’s assessment of the effectiveness of internal control over financial reporting, an enormously expensive proposition.

But as I mentioned at the top of this post, auditor attestation relief may be on the way. SEC Chairman Clayton has directed the Commission staff to formulate recommendations for possible changes to the accelerated filer definition to reduce the number of companies that fall under its requirements, including the auditor attestation requirement. Perhaps, the staff will recommend to increase the accelerated filer public float threshold to $250 million from its current $75 million. That would appear to bring far more practical regulatory relief than the expansion of the SRC definition.

Annex

Smaller Reporting Company Scaled Disclosure

Regulation S-K

Item

ScaledDisclosureAccommodation

101 − Description of Business

May satisfy disclosure obligations by describing the development of the registrant’s business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non-SRCs.

201 − Market Price of and Dividends on the Registrant’s Common Equity and Related

Maximum of two years of acquiree financial statements rather than three years.

8-05 – Pro forma Financial Information

Fewer circumstances under which pro forma financial statements are required.

8-06 – Real Estate Operations Acquired or to Be Acquired

Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.

8-08 – Age of Financial Statements

Less stringent age of financial statements requirements.

]]>Can a Digital Token Evolve? Head of Corp Fin Says “Yes”, if Network Becomes Decentralizedhttps://www.lexblog.com/2018/06/25/can-a-digital-token-evolve-head-of-corp-fin-says-yes-if-network-becomes-decentralized/
Tue, 26 Jun 2018 03:12:30 +0000https://lexblognetwork.wpengine.com/2018/06/25/can-a-digital-token-evolve-head-of-corp-fin-says-yes-if-network-becomes-decentralized/“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”

Such was the question posed by William Hinman, Director of the Securities and Exchange Commission’s Division of Corporation Finance, in his speech at the Yahoo Finance All Markets Summit: Crypto event in San Francisco on June 14. Hinman’s answer: a qualified “yes” where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created. This may be the most positive guidance yet from the SEC on when a digital asset might be deemed not to be a security under the Howey test. It may help create a pathway for blockchain startups to sell without registration or exemption digital tokens that had previously been sold in securities offerings, and should provide a measure of comfort to past and future issuers of SAFT-based ICOs.

After making his overarching point that a digital asset originally offered in a securities offering could be later sold in a manner that does not constitute an offering of a security when there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, Hinman went on to describe the circumstances under which he believes that could occur. In doing so, Hinman concentrated primarily on the last prong of the Howey test, namely whether an expectation of profit derived through the efforts of others, and suggested that the inquiry should focus on two areas: (i) who are the participants, and (ii) how is the digital asset structured?

Who are the Participants?

When determining whether a digital asset should be deemed to be an investment contract, Hinman stated that one should “consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.”

He suggested that this question will always depend on the particular facts and circumstances of a transaction, and offered the following non-exhaustive list of factors:

Promoter’s efforts play a significant role in the development and maintenance of the digital asset and its potential increase in value.

Promoter retains a stake or other interest in the digital asset such that he would be motivated to expend efforts to cause an increase in its value, particularly where purchasers are made to reasonably believe such efforts will be undertaken.

Amount raised in the ICO exceeds amount needed to establish a functional network and use of proceeds includes supporting the token’s value or increasing enterprise’s value

Promoter continues to expend funds from proceeds or operations to enhance functionality and/or value of system within which the tokens operate.

No persons or entities other than the promoter exercise governance rights or meaningful influence.

How is the digital asset structured?

Hinman then pointed to the existence of contractual or technical methods to structure digital assets so they function more like consumer items and less like a security, including the following:

Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?

Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?

Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?

Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?

Is the asset marketed and distributed to potential users or the general public?

Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?

Is the application fully functioning or in early stages of development?

Information Asymmetry

Director Hinman also pointed out that one of the rationales for the securities laws is to remove the information asymmetry between promoters and investors by mandating adequate disclosure to address that asymmetry. That disclosure regime is needed when a token purchaser relies on a token seller’s efforts to develop a network and generate a potential return on investment for the token purchaser.

Conversely, when the promoter’s efforts are no longer an important factor in determining the enterprise’s success, “material information asymmetries recede” and the protections of the securities laws may no longer be necessary. Moreover, as a practical matter, when a network becomes decentralized, the ability to identify a promoter to make the mandated disclosures “becomes difficult, and less meaningful.”

Implication for SAFTs

The Simple Agreement for Future Tokens or SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price. In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

In a SAFT-based ICO, the SAFT itself is generally acknowledged to be an investment contract and thus a security, and sold to accredited investors under Rule 506(c) of Regulation D. A quick search on EDGAR reveals there have been 37 Form D filings identifying the type of security offered as a SAFT. No court or regulator has interpreted the SAFT framework and whether or not the tokens to be ultimately issued are securities.

Director Hinman’s view that certain tokens initially issued by blockchain startups as securities may have the potential to become part of a decentralized network and no longer bear the attributes of securities may give legitimacy to SAFT-based ICOs. Interestingly, the only place where the word SAFT appears in the speech is in footnote 15 of the written version. In that footnote, Hinman states that although nothing in his remarks should be construed as opining on the legality of a SAFT (because the analysis of a particular SAFT must turn on the economic realities of the particular case), “it is clear from [his speech that he believes] that a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction.”

]]>SEC Reporting Companies Soon to be Regulation A+ Eligiblehttps://www.lexblog.com/2018/06/10/sec-reporting-companies-soon-to-be-regulation-a-eligible/
Mon, 11 Jun 2018 00:26:17 +0000https://lexblognetwork.wpengine.com/2018/06/10/sec-reporting-companies-soon-to-be-regulation-a-eligible/Buried in new legislation mainly intended to ease Dodd-Frank restrictions on small banks is an expansion of Regulation A eligibility to include SEC reporting companies. Previously, such companies were not eligible. The new access to Regulation A will create a viable mini-public offering pathway for SEC reporting companies, particularly those not eligible for registering securities on the streamlined Form S-3 registration statement.

Regulation A is an exemption from registration requirements for offerings of up to $50 million in any 12-month period, subject to eligibility, disclosure and reporting requirements. The exemption, often referred to as Regulation A+, provides for two tiers of offerings: Tier 1 for offerings of up to $20 million and Tier 2 for offerings of up to $50 million, in each case during any 12-month period. Tier 2 offerings are subject to additional disclosure and ongoing reporting requirements, but consequently benefit from preemption of state securities law registration and qualification requirements. As originally adopted, SEC reporting companies were not eligible to use Regulation A+.

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, which primarily is intended to ease the burdens on smaller banks under Dodd-Frank. Buried in the Act is Section 508, entitled “Improving Access to Capital”, which expands the availability of Regulation A+ by requiring the SEC to remove the requirement that the issuer not be an SEC reporting company. Section 508 also requires the SEC to amend Regulation A+ so that any company subject to Section 13 or 15(d) of the Exchange Act will be deemed to have met the periodic and current reporting requirements of Regulation A+ if it satisfies the Section 13 reporting requirements.

Currently, public companies seeking to conduct small public offerings in the range of up to $50 million would likely register such offering with the SEC through a streamlined registration statement on Form S-3, which has certain significant benefits. Form S-3 is a short-form registration statement which allows the issuer to update the registration statement’s disclosure prospectively through incorporation by reference of the issuer’s subsequently filed current reports on Form 8-K and periodic reports on Form 10-Q and Form 10-K. This “evergreen” feature means that a company generally will not need to file any post-effective amendments to the registration statement, a time and cost saving advantage.

The process of completing a registered offering on Form S-3 is generally quicker and cheaper than even a Reg A+ offering. So as a practical matter, it’s unlikely that S-3 eligible issuers will opt to do a Reg A+ offering over S-3.

But use of Form S-3 is subject to several stringent issuer and transaction eligibility requirements, including that the issuer be organized and have its principal business operations in the United States and that it have a public float, i.e., aggregate market value of common equity held by non-affiliates, of at least $75 million (unless it’s a listed company, limits the offering amount to not more than one-third of the company’s public float during any 12-month period and is not a shell company).

So issuers that are not S-3 eligible may decide that a Reg A+ offering is an attractive alternative for raising up to $50 million. The benefits of Reg A+, even to an SEC reporting company, could be significant: freedom to “test the waters” with investors prior to launch, faster SEC review relative to registered offerings and preemption of state blue sky registration in Tier 2 offerings.

]]>First S-1 Filing for an ICO: Going Legit or Just a Crypto Head Fake?https://www.lexblog.com/2018/05/06/first-s-1-filing-for-an-ico-going-legit-or-just-a-crypto-head-fake/
Mon, 07 May 2018 01:45:19 +0000https://lexblognetwork.wpengine.com/2018/05/06/first-s-1-filing-for-an-ico-going-legit-or-just-a-crypto-head-fake/Initial coin offerings so far have gone through two major phases in their brief lifespan. The initial phase flew under the regulatory radar in an explosion of deals that raised billions of dollars seemingly overnight and without either registering the offerings with the SEC or complying with an exemption from registration. The ICO atmosphere changed drastically when the SEC issued its now famous DAO report in July 2017, which together with subsequent speeches, written statements and enforcement actions took the position that tokens will generally be considered securities whose offering would need either to be registered with the SEC or qualify for a registration exemption such as Regulation D. That led to a second phase of issuers launching bifurcated ICOs consisting first of a sale of SAFTs to accredited investors under Regulation D, followed by the public sale of fully function tokens that sponsors would argue are not securities.

During the Senate’s February 6, 2018 committee hearing on cryptocurrencies, SEC Chairman Jay Clayton stressed the importance of disclosure for making informed decisions, but warned investors that no ICO had been registered with the SEC yet. That all seemed to change a month later when a group calling itself The Praetorian Group filed with the SEC a registration statement on Form S-1 to publicly offer and sell its cryptocurrency called PAX. With that S-1 filing, might we be entering a third phase of SEC-registered ICOs? For the reasons covered in this post, probably not.

The Registrant

The S-1 registration statement was filed by a company calling itself The Praetorian Group, and describes a dual business plan to be carried out in two phases. In the first phase, Praetorian will operate as a self-styled cryptocurrency real estate investment vehicle, or CREIV, through which it will purchase and upgrade residential and commercial real estate properties in lower income areas in New York, and then fund “outreach programs” to enrich the quality of life for the residents living in those properties. The second phase is projected to begin 12 months after the commencement of the first, and would involve the creation of a digital wallet that will convert cryptocurrencies (e.g., BTC, ETH, LTC, NEO, XLM) into local fiat currency and enable users to earn a reward in the form of PAX tokens for every purchase they make, which they can then spend, hold or sell.

What’s Wrong with this S-1?

The Praetorian S-1 is so deficient from a disclosure standpoint and so sloppy in its drafting that if the SEC bothered to review it, it may set some sort of record for number of comments in a comment letter.

Not to get overly picky, but the sloppiness starts right on the facing page. For starters, the registrant designates “The Praetorian Group” as its “exact name ... as specified in its charter”, leaving out the “Inc.” It provides that the approximate date of commencement of the proposed sale to the public is “upon SEC registration as a ‘security’”. Technically, issuers may only proceed with a public offering after their registration statement is declared effective by the SEC. Also, it appears Praetorian may have marked up the facing page from an old S-1 filing, as Praetorian’s facing page form is missing a reference to emerging growth companies (EGCs).

The EGC facing page omission leads me to a more substantive observation, which is that a registrant more serious about its offering would arguably have availed itself of a JOBS Act feature that allows EGCs to submit an S-1 confidentially and undergo an initial review off the EDGAR radar screen. Why not file confidentially and clear up any disclosure and accounting issues before having to file publicly? On that score, it’s entirely possible that Praetorian isn’t even the first ICO to file an S-1, and may have been beaten in a race to the SEC by a confidential EGC filer we don’t even know about yet.

One of the sections in the S-1 that really jumped out at me is a rather bizarre liability disclaimer, which reads as follows:

“To the maximum extent permitted by the applicable laws, regulations and rules the Company and/or the Distributor shall not be liable for any indirect, special, incidental, consequential, or other losses of any kind, in tort, contract, tax or otherwise (including but not limited to loss of revenue, income or profits, and loss of use or data), arising out of or in connection with any acceptance of or reliance on this Prospectus or any part thereof by you.”

Talk about an exercise in wishful thinking. Suffice it to say that I have never seen an issuer in a Securities Act registration statement attempt to disclaim liability for losses of any kind resulting from reliance on a prospectus. Federal securities law clearly allows a private plaintiff to recover damages for economic loss sustained as a result of an issuer’s material misstatements, omissions or fraud.

Pretty interesting given that Praetorian actually states that it’s “mindful of the uncertainties associated with the [SEC]’s view as to whether or not an [ICO] would constitute a ‘security’ under applicable federal securities laws” and consequently that they “believe it is more prudent to register the offering with the SEC to avoid any unanticipated regulatory issues”. It’s as if Praetorian is under the view that a registration statement is a notice filing, rather than a disclosure document to be vetted in great detail in a review process involving typically multiple rounds of comments followed by responses and registration statement amendments, and where issuers may not proceed with selling until the SEC is satisfied that all mandated disclosures have been made and accounting and other issues resolved and the SEC has declared the registration statement effective.

Another bizarre aspect of the S-1 is that Praetorian appears to be confused over whom it may sell to, or that it’s forgotten that it has filed a registration statement (which, if declared effective, would allow it to sell to anyone) and is not seeking to sell within the purchaser requirements of a given exemption:

“We strongly encourage each “accredited investor” to access the various SEC websites to gain a deeper and more knowledgeable understanding of this new form of digital currency prior to investing in the PAX token.”

Either Praetorian believes it may only sell in the public offering to accredited investors (as is the case in a private offering exemption under Rule 506(c)), or it strangely thinks that only accredited investors (which by definition must have a minimum net worth or annual income) need to be encouraged to inform themselves of the risks associated with ICOs.

Another glaring deficiency is the lack of risk factor disclosure. The only risk included in the section entitled “Risks and Uncertainties” is the risk that it may not be successful in achieving secondary market listings of the PAX token. Otherwise, the section simply consists of a conclusory statement that prospective purchasers of tokens should evaluate all risks and uncertainties associated with the company, the tokens, the token sale and the business plan prior to any purchase of tokens.

Finally, Praetorian’s S-1 omits in totality all of the information required in Part II of S-1. This includes expenses of issuance and distribution, indemnification of directors and officers, recent sales of unregistered securities, exhibits, financial statement schedules and certain required undertakings.

Conclusion

The Praetorian Guard was an elite unit of the Imperial Roman Army whose members served as personal bodyguards to the Roman emperors, sort of like the Roman equivalent of today’s Secret Service that protects the President. Although the ancient Praetorians continued to serve in that capacity for roughly three centuries, they became notable for their intrigue and interference in Roman politics, including overthrowing emperors and proclaiming successors. In the year 312, the Praetorian Guard was disbanded by Constantine the Great. Like its namesake, The Praetorian Group has generated a fair amount of intrigue with its S-1 filing, but I can only imagine that the great examiners of the SEC will take a page out of Constantine’s playbook and disband this Praetorian Group’s S-1 registration statement.

]]>Hand it Over: SAFT-Based ICOs Challenged by SEC Subpoenashttps://www.lexblog.com/2018/03/22/sec-subpoenas-of-ico-issuers-and-implications-for-saft-based-icos/
Thu, 22 Mar 2018 19:15:08 +0000https://lexblognetwork.wpengine.com/2018/03/22/sec-subpoenas-of-ico-issuers-and-implications-for-saft-based-icos/The Wall Street Journal ominously reported on February 28 that the Securities and Exchange Commission recently issued dozens of subpoenas to initial coin offering issuers and their advisors demanding information about the structure of their ICOs. Although the Commission has yet to officially acknowledge them, the subpoenas are consistent with a series of SEC enforcement actions alleging fraud or illegal sale of securities (see, e.g., here and here) and public speeches and statements warning ICO participants about regulatory compliance and promising greater scrutiny and enforcement (see, e.g., here, here and here). Nevertheless, the enforcement actions and speeches don’t appear to have had much success in slowing down the pace of the ICO market. Coinschedule reports that ICOs have raised over $3.3 billion in 88 deals already in 2018 through March 16, and is on pace to exceed the estimated $5.6 billion raised in 2017. The latest SEC subpoena campaign coupled with the accelerating pace of deals suggests the Commission believes its message is not resonating in the ICO market.

Although I’m grateful I didn’t find one of the subpoenas in my mailbox, I’m definitely curious about their contents. Coindesk quotes industry sources who have seen several of the ICO subpoenas as saying that the requested information includes investor lists, emails, marketing materials, organizational structures, amounts raised, location of funds and people involved and their locations. It also cites an anonymous industry lawyer saying that the 25-page subpoena received by his client was “hyper-detailed” and that it asked for “every bit of communication around the token launch.”

So what exactly is the Commission focusing on? Many naturally believe the Commission is primarily targeting fraud. But the Journal, Coindesk and others suggest a different focus: Simple Agreements for Future Tokens or SAFTs.

The SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price. In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

There should be no controversy regarding the SAFT itself (as opposed to the tokens that ultimately get issued). Protocol Labs and Cooley’s SAFT White Paper states in no uncertain terms that the SAFT is a security and must satisfy an exemption from registration, and contemplates compliance with Rule 506(c) under Regulation D. I haven’t seen or heard anyone suggesting otherwise. In fact, each SAFT investor is required to represent in the SAFT that it “has no intent to use or consume any or all Tokens on the corresponding blockchain network for the Tokens after Network Launch” and “enters into this security instrument purely to realize profits that accrue from purchasing Tokens at the Discount Price”. Accordingly, there should be no Federal securities law issue with the issuance of the SAFT itself, assuming of course that the issuer complies with Rule 506(c)’s requirements, i.e., disclosure obligations, selling only to accredited investors, using reasonable methods to verify accredited investor status and filing Form D.

The real issue is whether the eventual tokens, assuming they are issued to investors only when the network is created and the tokens fully functional, are necessarily not securities because of their full functionality. SAFT proponents argue that fully functional tokens fail the “expectation of profits” and/or the “through the efforts of others” prongs of the Howey test, and thus should not be deemed to be securities. The SAFT White Paper analyzes these two prongs of the test from the perspective of the two likely categories of purchasers of tokens: actual token users and investors. In the case of actual users, their bona fide desire to make direct use of the relevant consumptive aspect of a token on a blockchain-based platform predominates their profit-seeking motives, so arguably they fail the “expectation of profit” prong of Howey. Investors, on the other hand, clearly expect a profit from resale of the tokens on a secondary market; that profit expectation, however, is usually not predominantly “through the efforts of others” (because management has already brought the tokens to full functionality) but rather from the myriad of factors that cause the price of assets to increase or decrease on an open market.

Opponents of the SAFT approach (see, e.g., Cardozo Blockchain Project’s Not So Fast—Risks Related to the Use of a “SAFT” for Token Sales) reject the concept of a bright-line test, i.e., they reject the notion that the question of whether a utility token will be deemed a security solely turns on whether the token is “fully functional”. They maintain that courts and the SEC have repeatedly, and unambiguously, stated that the question of whether or not an instrument is a security is not subject to a bright-line test but rather an examination of the facts, circumstances and economic realities of the transaction. Opponents also assert that the SAFT approach actually runs the risk of increasing regulatory scrutiny of utility token issuers because of the emphasis on the speculative, profit-generating aspects of the utility tokens (e.g., the investor reps referred to above), which could ironically transform an inherently consumptive digital good (the token itself) into an investment contract subject to federal securities laws. Others have suggested that reliance on the efforts of management doesn’t end with full functionality of the tokens, and that ultimately the success of the network and hence the investment will turn on whether management is successful in overcoming competition.

If anything, the Commission’s subpoena campaign suggests that the SAFT opponents correctly predicted the increased regulatory scrutiny. And the increased regulatory scrutiny through the subpoena campaign is a stark warning to ICO issuers and counsel that SAFTs may not be completely safe after all.

]]>Dropbox IPO Multi-Class Structure: Bad Corporate Governance or Good Long Term Focus?https://www.lexblog.com/2018/02/25/dropbox-ipo-multi-class-structure-bad-corporate-governance-or-good-long-term-focus/
Mon, 26 Feb 2018 01:59:06 +0000https://lexblognetwork.wpengine.com/2018/02/25/dropbox-ipo-multi-class-structure-bad-corporate-governance-or-good-long-term-focus/Dual or multi-class capitalization structures generally allow companies to sell large amounts of shares to the public while maintaining control in the hands of the founders and early investors. Popularized by the Google IPO in 2004, weighted voting rights have since been featured in the high profile IPOs of LinkedIn, Groupon, Zynga, Facebook, Fitbit and Blue Apron. Snap then took them to a new level last year when it acknowledged (or boasted) that it was the first company to launch an IPO with shares having zero voting rights. I blogged about Snap’s IPO here.

Dropbox, Inc. is now the latest to go public with a multi-class structure. Having submitted its registration statement confidentially in early January, Dropbox finally filed its S-1 publicly on February 23. Dropbox’s S-1 shows that its capital structure consists of three classes of authorized common – Class A, Class B and Class C – with the rights of the holders of all three classes being identical except with respect to voting. Class A shares (offered to the public) are entitled to one vote per share, Class B shares are entitled to ten votes per share and Class C shares have no voting rights, except as otherwise required by law. Although the general rule in Delaware is that each share receives one vote, a corporation may provide in its certificate of incorporation that a particular class or series has limited or no voting rights.

Because of the ten-to-one vote ratio between Dropbox’s Class B and Class A, the Class B stockholders – basically the co-founders and lead VCs Sequoia, Accel and T. Rowe Price — will continue to control a majority of the combined voting power, and therefore be able to control all matters submitted to stockholders for approval. This concentrated control will limit or preclude the Series A holders from having an influence over corporate matters for the foreseeable future, including the election of directors, amendments of the certificate of incorporation and by-laws and any merger, sale of all or substantially all the assets or other major transaction requiring stockholder approval. The concentration of voting power may also discourage unsolicited acquisition proposals.

The concentration of power in the Dropbox founders will likely only grow over time. Under an automatic conversion feature, future transfers of Class B shares will generally result in conversion into the lower voting Class A shares, subject to limited carve-outs for estate planning transfers and transfers between co-founders. The conversion of Class B shares to Class A will have the effect, over time, of increasing the relative voting power of those Class B holders who retain their shares. Moreover, any future offerings of Class C shares will increase the concentration of ownership and control by the founders even further than would be the case in an offering of A shares because the C shares carry no voting rights at all (except as otherwise required by law). Consequently, the cumulative effect of the disproportionate voting power of the B shares, the automatic conversion feature upon transfer of B shares and the possibility of issuance of C shares is that the founders may be able to elect all of Dropbox’s directors and to determine the outcome of most matters submitted to a stockholder vote indefinitely.

Dual-class structures have been the subject of a great deal of controversy. Some stock exchanges had banned them, only to reverse course because of stiff competition for listings. See here for case in point regarding Hong Kong, the NYSE and Ali Baba. Investors have loudly objected to this structure, both through the SEC’s Investor Advisory Committeeand the Council of Institutional Investors. As a result of that opposition, FTSE Russell and Standard & Poor’s announced last year that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their broad stock indices. Affected indices include the Russell 2000 and the S&P 500, S&P MidCap 400 and S&P SmallCap 600. Consequently, mutual funds, exchange-traded funds and other investment vehicles that attempt to passively track these indices will not be investing in the stock of any company with dual-class shares. Although it’s too early to tell for sure what impact, if any, these new index policies will have on the valuations of Dropbox and other publicly traded companies excluded from the indices, it’s entirely possible that the exclusions may depress these valuations compared to those of similar companies that are included in the indices. Interestingly, just two weeks ago, SEC Commissioner Robert J. Jackson Jr. gave his first speech since being appointed, entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty“, in which he expressed his opposition to index exclusions despite his serious concerns regarding dual-class stock, calling index exclusion a blunt instrument and worrying that “Main Street investors may lose out on the chance to be a part of the growth of our most innovative companies”.

And how do companies like Dropbox defend dual-class structures? They would assert that weighted voting rights enable management to make long term decisions that are in the best interests of the company and to resist the short-termism that typically results from pressure brought by major stockholders to maximize quarterly results which often means sacrificing long term interests and performance. They would further argue that efforts to exclude companies with weighted voting rights from stock indices are counter-productive because they serve to discourage those companies from going public in the first place, thus denying public company investors the opportunity to invest in innovative, high growth companies.

Perhaps the sensible compromise here would be sunset provisions, under which dual-class structures would sunset after a fixed period of time, such as five, ten or fifteen years, unless their extension is approved by stockholders unaffiliated with the controlling group. Snap’s muti-class structure has no sunset provision; the only way the two founders could ever effectively lose control of Snap is if both died. By contrast, Google has a sunset provision on its dual-class shares. The Council of Institutional Investors sent a noisy letter to Blue Apron just before its IPO last year urging the company to adopt a five-year sunset. And Harvard Professor Lucien Bebchuck published a paper last year called “The Untenable Case for Perpetual Dual-Class Stock”, arguing that the potential advantages of dual-class structures tend to recede, and the potential costs tend to rise, as time passes from the IPO, and advocating for finite-term dual-class structures.

]]>Regulation Crowdfunding Surpasses $100 Million but Still Needs Reformhttps://www.lexblog.com/2018/02/19/regulation-crowdfunding-surpasses-100-million-but-still-needs-reform/
Tue, 20 Feb 2018 01:12:23 +0000https://lexblognetwork.wpengine.com/2018/02/19/regulation-crowdfunding-surpasses-100-million-but-still-needs-reform/A recent report on the state of Regulation Crowdfunding published by a major crowdfunding advisory firm is cause for both celebration and renewed reform efforts. The $100 million aggregate funding milestone and the prorated year over year growth data indicate that the market, while still in its infancy, is growing at a nice pace. Nevertheless, a closer look at the data suggests that Regulation Crowdfunding in its current framework is not reaching its potential and remains in serious need of reform.

The Report

The 2017 State of Regulation Crowdfunding, published by crowdfunding advisory firm Crowdfund Capital Advisors, contains several helpful points of data and analysis. The data in the report were retrieved from the various forms that are required to be filed by issuers in Regulation CF equity crowdfunding transactions under Title III of the JOBS Act, which are publicly available on the SEC’s EDGAR website. These include offering statements on Form C, amendments to those statements on Form C/A, offering progress updates on Form C-U and annual reports on Form C-AR.

The report could be downloaded for free here. Some of the key findings are as follows:

The number of unique offerings increased 267% from 178 in 2016 to 481 in 2017.

Proceeds increased 178% from $27.6 million in 2016 to $49.2 million in 2017.

As of today, there are $100,072,759 in aggregate capital commitments.

The number of successful offerings increased 202% from 99 in 2016 to 200 in 2017

The total number of investors in Reg CF investments increased 158% from 28,180 in 2016 to 44,433 in 2017.

The foregoing data need to be put into some context. First, Reg CF only went live on May 16, 2016, and so the year against which 2017 is compared is only slightly over one-half of a calendar year; data from that year should be annualized to reflect the fact that deals were only happening for approximately 65% of the year. Also, on the advice of funding portals, issuers are setting extremely low target offering amounts, in some cases as low as $10,700 (1% of the maximum allowed in any rolling 12-month period). Accordingly, the above data on successful offerings may need to be viewed somewhat skeptically to the extent “successful offering” is determined based on whether or not an issuer exceeded its own stated targeted offering amount.

The report also offers the following points of analysis:

The market is growing at a rapid pace.

The pace of capital into funded offerings appears to be steady without showing signs of abnormal activity or irrational investor behavior.

The rapid increase in the number of offerings and investors proves that there is appetite for Reg CF from both issuers and investors.

Given the lack of irregularities or fraud, Reg CF (and the structure under which it provides for transparency) should be advocated by policy makers and government organizations.

The report does not offer data to support the premise of that last point, i.e., that there exists a lack of irregularities or fraud.

But We Still Need Further Reform

While the $100 million milestone should be cheered, there are objective reasons to believe that Reg CF is grossly underperforming as a capital raising pathway and failing to meet its potential. It was intended to democratize startup investment, to enable hundreds of millions of people who were effectively shut out of private offerings because of their lack of accredited investor status to invest in these deals for the first time. It’s believed that over 90% of the U.S. population would fall into that category and that there’s an estimated $30 trillion socked away in their savings accounts. If only 1% of that were to be reallocated to Reg CF deals, we’d be seeing a market of $300 billion dollars, which would dwarf the $72 billion in U.S. VC investment in 2017.

Which leads me to the need for further reform. Much has already been said about the low $1.07 million cap on issuers. Although the cap should certainly be raised to balance out the amount raised with the disclosure, filing and other burdensome requirements as well as to make Reg CF more competitive with other available pathways, the reality is that most Reg CF offerings are not even reaching the existing cap. That suggests that there must be other impediments in the rules that should be addressed to help companies raise permissible amounts.

Chief among these impediments in my view is the exclusion of investment vehicles from Reg CF. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

Reg CF should also be reformed to raise the investment caps for investors. Currently, investors are capped based on their income or net worth, with a separate hard cap irrespective of net worth or income. At a minimum, there should be no hard cap for accredited investors. Makes no sense that Mark Zuckerberg be capped at $107,000.

Finally, under current rules, any Reg CF funded company that crosses a $25 million asset threshold would be required to register with the SEC under the Securities Exchange Act and become an SEC reporting company. This would have the potential to create a perverse incentive for a company not to grow, and seems inconsistent with the spirit of Reg CF, which for the first time allows companies to fund their growth by offering securities to the public without registering with the SEC. The asset threshold triggering Exchange Act registration should either be raised or eliminated.

Although Reg CF is still in its infancy and the data in the report could be read to indicate steady growth in a seemingly healthy emerging market, there is also reason to believe that the market has not even begun to tap its potential, a potential that may never be realized if perceived impediments are not mitigated or removed.

]]>Massachusetts’ First ICO Enforcement Action Offers Important Lessons for Offshore ICOshttps://www.lexblog.com/2018/02/04/massachusetts-first-ico-enforcement-action-offers-important-lessons-for-offshore-icos/
Mon, 05 Feb 2018 02:17:53 +0000https://lexblognetwork.wpengine.com/2018/02/04/massachusetts-first-ico-enforcement-action-offers-important-lessons-for-offshore-icos/Last month, Secretary of the Commonwealth of Massachusetts William Galvin made good on his promise to conduct an exam sweep of ICOs in Massachusetts. On January 17, the Enforcement Section of the Massachusetts Securities Division brought its first ICO related enforcement action, an administrative complaint against a company called Caviar and its founder Kirill Bensonoff for violations of state securities laws in connection with Caviar’s ICO. The complaint likely portends increased willingness on the part of state securities administrators to bring enforcement actions against ICO sponsors. It also offers important lessons about how to conduct offshore ICOs so as to minimize the risk of offers and sales being deemed to be made to U.S. residents.

The complaint tells us that Caviar is a Cayman Islands company that has no actual place of business there, operating instead principally in founder Bensonoff’s home in Massachusetts.

The Caviar token offered in the ICO (CAV) was clearly a securities token; no pretense of a utility token here. Proceeds from the ICO were to be pooled and used to finance the acquisition of a portfolio of various cryptocurrencies, and also to finance short term “flips” of residential real estate properties. Purchasers of CAV tokens were told they would receive quarterly dividends equal to their pro rata share of 75% of the combined profits from this pooled investment fund of cryptocurrencies and real estate debt. Basically, Caviar was a virtual hedge fund and its tokens had key attributes of limited partnership or membership interests, i.e., they were securities.

The real interesting issue in this dispute would seem to be whether the offering was properly conducted offshore as intended and thus outside the jurisdiction of Massachusetts’ Securities Division (or any other securities regulators in the U.S.). Caviar’s argument would seem to be that the offering was made offshore and that they employed safeguards to ensure that no offers and sales were made to United States persons. Caviar’s ICO white paper states that United States persons (within the meaning of Rule 902 of Regulation S) are excluded from the offering and are explicitly restricted from purchasing CAV.

Before the complaint was filed, investors apparently had been purchasing CAV by visiting Caviar’s website at www.caviar.io (after the complaint was filed, the site was modified to greet U.S. persons with the following message: “It appears you are accessing caviar.io from United States of America. Unfortunately, this website is not available in the United States of America.”). To register for the offering, prospective investors were asked to provide an e-mail address and check two boxes. The first box indicated “Not U.S. person”, and the second box stated that the investor consulted with an experienced lawyer who advised the investor that he or she is eligible to invest. Caviar retained the services of an independent third party to screen out ineligible persons based on internet protocol addresses, i.e., numeric labels assigned to users or devices by internet service providers. If an individual was identified as a potentially prohibited purchaser, he or she would be prompted to upload copies of a government-issued photo identification. In sworn testimony given by Bensonoff before the Securities Division in this matter, he stated that “as far as [he knows], there’s not a single U.S. investor who has contributed.”

In the complaint, the Securities Division asserts that Caviar’s procedures to prevent the sale of CAV to U.S. investors are inadequate because Caviar’s identity verification procedures were relatively easy to circumvent. To prove the point, it had one of its investigators apply to participate in the Caviar ICO using the name of a “popular cartoon character”. The complaint doesn’t identify the cartoon character, perhaps in an effort to protect the Securities Division’s sources (if not its methods). When prompted to upload a photo ID (apparently because the investigator’s IP address indicated he was located in the U.S.), the investigator uploaded a photo of a government-issued photo ID obtained using a Google Image search. But the name, address, and date of birth listed on the submitted ID image didn’t match the personal information provided earlier by the investigator. Nevertheless, the investigator’s identity was “verified,” and the investigator was approved to participate in the Caviar ICO.

The complaint brought by the Massachusetts Securities Division offers some useful lessons for properly conducting an offshore ICO. First, investor check-the-box self-certification will not suffice in the absence of effective verification measures by the sponsor to screen out ineligible persons. Second, inasmuch as it’s possible to identify applicants’ approximate geolocation based on internet protocol addresses, offshore ICO sponsors should carefully monitor the IP addresses of online investor applicants. Third, all applicants should be prompted to upload a copy of a government-issued photo ID, which should be carefully checked by the sponsor (either directly or through independent third parties) against other personal information provided by the investor. Fourth, any attempt emanating from a U.S. IP address to open a link to an offshore ICO site should be directed to an alternate dead-end page that states nothing more than that the person seeking access appears to be in the U.S. and that the website is not available in the U.S. Finally, a sponsor’s culpability will not be mitigated by lack of actual knowledge of any U.S. person purchases.

]]>Better Part of Valor: Delaware Supreme Court Rules No Ratification Defense for Director Grants under Discretionary Planshttps://www.lexblog.com/2018/01/10/better-part-of-valor-delaware-supreme-court-rules-no-ratification-defense-for-director-grants-under-discretionary-plans/
Wed, 10 Jan 2018 19:40:17 +0000https://lexblognetwork.wpengine.com/2018/01/10/better-part-of-valor-delaware-supreme-court-rules-no-ratification-defense-for-director-grants-under-discretionary-plans/What happens when corporate directors approve their own awards under an equity incentive plan? Under Delaware law, so long as the plan is approved by a majority of the fully informed, uncoerced and disinterested stockholders, the awards will generally be protected by the business judgment rule and judges will not second guess them. Or will they?

Last month, the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation ruled that awards made by directors to themselves under equity incentive plans approved by the stockholders should nevertheless be subject to the more demanding entire fairness standard, requiring the directors to prove that the terms are fair to the corporation, if the plan lacks fixed criteria and gives the board discretion in granting themselves awards. The ruling represents a departure from an earlier line of Delaware cases that held that the ratification defense would be available and the business judgment rule would protect grants to directors so long as the plan approved by the stockholders contained meaningful limits on awards to directors. After Investors Bancorp, director awards under stockholder-approved equity incentive plans will only benefit from the business judgment rule if the plan gives directors no discretion in making awards to themselves.

Delaware law authorizes a board of directors to determine its own compensation. Because directors are necessarily conflicted when compensating themselves, however, such decisions generally fall outside the protection of the business judgment rule and instead are subject to the entire fairness standard, meaning that if properly challenged as a breach of fiduciary duty the directors must prove those compensation arrangements are fair to the corporation. Depending on the circumstances, however, conflicted director transactions can generally avoid application of the entire fairness standard through stockholder ratification.

Courts have traditionally recognized the ratification defense in three situations involving director awards: (i) when stockholders approve the specific director awards, (ii) when the plan is self-executing (meaning the directors have no discretion in making the awards), and (iii) when directors exercise discretion and determine the amounts and terms of the awards after stockholder approval. The first two scenarios present no real substantive problems. The third scenario is more challenging, and was the issue addressed in Investors Bancorp.

Stockholders of Investors Bancorp approved an equity incentive plan that gave discretion to the directors to allocate up to 30% of all option or restricted stock shares under the plan to themselves, but the number, types and terms of awards to be made pursuant to the plan were subject to the discretion of the board’s compensation committee. After the Investors Bancorp stockholders approved the plan, the board granted just under half of the stock options available to the directors and nearly thirty percent of the shares available to the directors as restricted stock awards.

The plaintiffs argued that the directors breached their fiduciary duties by granting themselves these awards because they were unfair and excessive. According to the plaintiffs, the stockholders were told the plan would reward future performance, but the board instead used the awards to reward past efforts which the directors had already accounted for in determining their compensation packages. Also, according to the plaintiffs, the rewards were inordinately higher than those at peer companies. The court ruled that the plaintiffs properly alleged that the directors acted inequitably in exercising their discretion and granting themselves unfair and excessive awards, and, because the stockholders did not ratify the specific awards under the plan, the affirmative defense of ratification was unavailable.

There are two key takeaways here. First, inasmuch as director grants under discretionary plans will no longer benefit from stockholder ratification after Investors Bancorp, companies contemplating adoption of equity incentive plans should think seriously about making sure those plans are self-executing and contain no discretionary elements as to grants to directors. An example of a self-executing plan would be one in which each director is granted an option to purchase “x” shares upon election to the board and an additional “y” shares on the anniversary of his or her election. Second, existing equity incentive plans should be carefully reviewed to determine whether or not they are discretionary, and any proposed grants under discretionary plans, even if ratified by the stockholders, should be carefully vetted to ensure they are consistent with information disclosed to stockholders at the time of plan approval and reasonable under objective standards such as in relation to a peer group.

]]>Company Abandons ICO, Agrees to Cease-and-Desist; SEC Chairman Issues ICO Warninghttps://www.lexblog.com/2017/12/17/sec-order-and-chairmans-statement-signal-resolve-to-apply-securities-laws-to-icos/
Mon, 18 Dec 2017 03:38:28 +0000https://lexblognetwork.wpengine.com/2017/12/17/sec-order-and-chairmans-statement-signal-resolve-to-apply-securities-laws-to-icos/December 11, 2017 was a day of reckoning for entrepreneurs conducting or contemplating initial coin offerings, and for securities professionals who advise them. First, a company selling digital tokens to investors to raise capital for its blockchain-based food review service abandoned its initial coin offering after being “contacted” by the Securities and Exchange Commission, and agreed to a cease-and-desist order in which the SEC found that its ICO constituted an unregistered offer and sale of securities. On the same day, SEC Chairman Jay Clayton issued a “Statement on Cryptocurrencies and Initial Coin Offerings”, warning “Main Street” investors and market professionals about investing and participating in ICOs, and reiterated the SEC’s determination to apply the securities laws to transactions in digital tokens. These two actions are the latest in a series of steps by the SEC to send a clear message that it intends generally to enforce the securities laws with respect to ICOs that emphasize the profit potential of tokens where such profit derives from the efforts of the entrepreneurs of the underlying project.

Cease and Desist Order

Munchee Inc. is a California-based company that developed an iPhone app for people to review restaurant meals. In October and November 2017, Munchee offered and then sold digital tokens it called “MUN” to be issued on a blockchain, seeking to raise approximately $15 million to improve the app and recruit users to eventually buy ads, write reviews, sell food and conduct other transactions using MUN. On or about October 31, 2017, Munchee started selling the MUN tokens. The next day, Munchee was “contacted” by the SEC staff, probably threatening cease and desist proceedings. The message was communicated loud and clear, because within hours Munchee stopped selling MUN tokens and promptly returned to purchasers the proceeds that it had already received. In anticipation of the institution of cease and desist proceedings, Munchee submitted an offer of settlement and consented to entry of the cease-and-desist order.

Despite Munchee holding itself out as offering a utility token that is not a security, the SEC’s position was that the MUN token was a security because the totality of Munchee’s efforts relating to the ICO resulted in a purchasers’ reasonable expectation of profits from the entrepreneurial efforts of Munchee’s management team. Interestingly, Munchee’s white paper included a three page legal disclaimer stating that it conducted a Howey analysis with the assistance of counsel and concluded that its MUN utility token didn’t pose a “significant risk of implicating federal securities laws”. As the order notes, however, the white paper did not set forth the actual analysis.

The SEC’s case that Munchee’s ICO of MUN tokens was a securities offering rests largely on the following arguments:

Token purchasers were led to believe that efforts by Munchee would result in an increase in value of the tokens.

Increase in value of the MUN tokens would occur whether or not purchasers ever used the Munchee restaurant app or otherwise participated in the MUN “ecosystem”.

Munchee emphasized it would take steps to create and support a secondary market for the tokens.

Promotional efforts included blatant predictions of increase in value of the token.

The ICO targeted digital asset investors, as opposed to targeting current users of the Munchee app or restaurant owners regarding the utility of the tokens.

ICO was promoted in worldwide publications, despite the app only being available in the United States.

Munchee paid people to translate offering documents into multiple languages, presumably to reach potential investors in other countries where the Munchee app was unavailable.

The order asserts that in the course of the ICO, Munchie and its promoters emphasized that investors could expect that there would be an increase in value of the MUN tokens resulting from efforts by Munchie, including paying users in MUN tokens for writing food reviews, selling both advertising to restaurants and “in-app” purchases to app users in exchange for MUN tokens, and working with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users in MUN tokens.

Munchee also emphasized in the ICO that it would take steps to create and support a secondary market for its tokens, including potentially burning (i.e., taking out of circulation) a small fraction of MUN tokens whenever a restaurant pays Munchee an advertising fee and buying or selling MUN tokens using its retained holdings in order to ensure there was a liquid secondary market for MUN tokens.

The SEC chose not to impose a civil penalty here, largely because of the remedial acts promptly undertaken by Munchee and the cooperation it afforded to the SEC staff. Instead, the SEC ordered Munchee to cease and desist from committing or causing any violations and any future violations of Sections 5(a) and (c) of the Securities Act. This is no slap on the wrist, however, inasmuch as it disqualifies Munchee from engaging in the next five years in an offering exempt under Regulation A or Rule 506 of Regulation D, the two likely securities exemptions for ICOs.

Chairman Clayton’s Statement

On the same day as the Munchee cease-and-desist order, SEC Chairman Jay Clayton issued a “Statement on Cryptocurrencies and Initial Coin Offerings” directed principally at “Main Street” investors and market professionals (including broker-dealers, investment advisers, exchanges, lawyers and accountants). The Statement asserts that in the aftermath of the SEC’s July 2017 investigative report applying securities law principles to demonstrate that the DAO token constituted an investment contract and therefore was a security, certain market professionals had attempted to highlight utility characteristics of their proposed tokens in an effort to claim that the tokens were not securities. “Many of these assertions appear to elevate form over substance”, Chairman Clayton noted, and that “replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance”.

Particularly chilling for me as a securities lawyer was the following admonition by Chairman Clayton:

“On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors” (bold appears in original Statement).”

In the Statement, Chairman Clayton presents interesting hypothetical contrasting business models for the distribution of books to illustrate the difference between a utility token and a securities token. An example of what would be characterized as a utility token that’s not a security would be a book-of the-month club selling tokens representing participation interests in the club as simply an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast are interests in a yet-to-be-built publishing house where the token purchasers have a reasonable expectation of profit through the entrepreneurial efforts of the founders to organize the publisher’s authors, books and distribution networks. Chairman Clayton added that an additional circumstance contributing to a conclusion that a utility token is a security would be when promoters tout the secondary market trading potential of their tokens and the potential for the tokens to increase in value, which are “key hallmarks of a security and a securities offering”.

There should be no doubt about the seriousness with which Chairman Clayton is approaching the issue. Toward the end of the Statement, he states that he has “asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws”.

]]>Is a Utility Token ICO a Sale of Securities?https://www.lexblog.com/2017/11/05/is-a-utility-token-ico-a-sale-of-securities/
Mon, 06 Nov 2017 00:15:39 +0000https://lexblognetwork.wpengine.com/2017/11/05/is-a-utility-token-ico-a-sale-of-securities/Bloomberg reported on October 16 that over $3 billion dollars have been raised in over 200 initial coin offerings so far this year. It remains to be seen whether the pace of ICOs will slow down in the face of regulatory headwinds such as the outright ICO bans in China and South Korea. Here in the United States, the Securities and Exchange Commission has been sounding alarm bells. On July 25, the SEC’s Division of Enforcement issued a Report of Investigation finding that tokens offered and sold by a virtual organization known as “The DAO” were securities and therefore subject to the federal securities laws. I blogged about it here. On the same day the SEC issued the report, its Office of Investor Education and Advocacy issued an investor bulletin to make investors aware of potential risks of participating in ICOs. Then on September 29, it charged a businessman and two companies with defrauding investors in a pair of ICOs purportedly backed by investments in real estate and diamonds. And on November 1, it issued a “Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others”, warning that any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

Needless to say, the days of ICOs flying below the SEC’s radar are over, and developers conducting token sales to fund the development of a network need to be aware of the securities law implications of the sale. In its Report of Investigation, the SEC made clear (what most of us suspected all along) that the traditional Howey test for determining whether a funding mechanism is an ”investment contract” and thus a “security” applies to blockchain based tokens. I won’t go into a deep dive here. For those wanting to jump into the weeds, Debevoise has done a pretty good job on this. But the basic test under Howey is that an agreement constitutes an investment contract that meets the definition of a “security” if there is (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) solely from the efforts of others.

It’s useful to consider that blockchain tokens fall generally into two broad categories. “Securities tokens” are basically like shares in a corporation or membership interests in a limited liability company where the purchaser receives an economic right to a proportional share of distributions from profits or a sale of the company. On the other hand, “utility tokens” don’t purport to offer purchasers an interest or share in the seller entity itself but rather access to the product or service the seller is developing or has developed. Unfortunately, there exists virtually no SEC or case law guidance on securities law aspects of utility tokens. The token at issue in the SEC’s investigative report on The DAO was a securities token. The DAO was a smart contract on the Ethereum blockchain that operated like a virtual venture fund. Purchasers would share in profits from the DAO’s investments and so the tokens were like limited partnership interests.

The question of whether utility tokens are securities may turn on whether the blockchain network for which the tokens will function is fully functional or still in development, and an interesting debate has emerged as to whether there should be a bright line test on that basis.

One side of the debate, advanced by Cooley (Marco Santori) and Protocol Labs (Juan Batiz-Benet and Jesse Clayburgh), is that purchasers of utility tokens prior to network launch and before genuine utility necessarily rely on the managerial and technical efforts of the developers to realize value from their tokens. Accordingly, agreements for the sale of pre-functional tokens meet the “expectation of profit” and “through the efforts of others” prongs of Howey and should be characterized as securities. On the other hand, fully functional utility tokens should not be considered securities because they fail the “through the efforts of others” prong of Howey and maybe even the “expectation of profit” prong. Purchasers of fully functional tokens are likely to be people seeking access to the seller’s network as consumers or app developers with any expectation of profit from appreciation of the tokens being a secondary motivation, so the expectation of profit prong of Howey fails as to those purchasers. The same conclusion should apply even as to the other type of purchaser who is motivated primarily by the prospect of a token resale for profit because the profit that is hoped for is not expected to come through the managerial or entrepreneurial efforts of the developers, but rather through the many different independent forces that drive supply and demand for the tokens. There is a line of cases involving contracts for the purchase of commodities holding that they are not securities because the expectation of profit was solely from fluctuations in the secondary market, and not from any efforts on the part of the producer. Fully functional tokens are analogous to commodities in that the token developers have completed development of the network, and so there should not be any expectation that profit will result from any further efforts by the seller.

On the other side of the debate is Debevoise, which advocates for a facts and circumstances approach, rejects the bright line test of whether or not a utility token is fully functional and offers several arguments. The determination of whether an agreement is an investment contract and thus a security has long been based upon a facts and circumstances analysis. A blockchain token is not a homogenous asset class; a token could be a digital representation of an equity or debt security but it could also represent things like hospital records or a person’s identity, and that particular character of the token is unaffected by whether the network is or is not fully functional. Also, there is an implicit recognition in the JOBS Act that pre-order sales on non-equity crowdfunding sites like Kickstarter and Indiegogo are not sales of securities, and that pre-functional utility token sales should be analyzed the same way. It also questions whether agreements by a mature company to presell a new product in development would automatically be deemed an investment contract. Finally, there’s the difficulty of determining when exactly a token is fully-functional given the complexity of software and network development.

Seems to me that the arguments on both sides of the utility token debate have merit. I do think there’s a distinction, though, between pre-order sales of product by a mature company and a sale of pre-functional tokens, in that the tokens most likely can be sold on a secondary market, with any profit likely resulting from the entrepreneurial efforts of the developer. I also think that until we have guidance from the SEC and/or judicial opinions on the issue, the better approach is to treat clearly pre-functional tokens as investment contracts and conduct their sale under an exemption from registration.

]]>What Can’t be Cured, Must be Endured: Delaware Limits Defective Corporate Act Ratificationhttps://www.lexblog.com/2017/10/09/what-cant-be-cured-must-be-endured-delaware-limits-defective-corporate-act-ratification/
Mon, 09 Oct 2017 20:29:13 +0000https://lexblognetwork.wpengine.com/2017/10/09/what-cant-be-cured-must-be-endured-delaware-limits-defective-corporate-act-ratification/A recent Delaware Chancery Court decision provides important guidance on what types of defective corporate acts may be ratified under Section 204 of the Delaware General Corporation Law (the “DGCL”), and what types may not. Paul Nguyen v. View, Inc. also underscores the importance of focusing on whether to opt out of the class vote required by DGCL Section 242(b)(2) for changes in authorized capital, which effectively gives the common stock a veto over future funding rounds.

The facts of the case are as follows. View, Inc. develops smart windows that allow the light, heat, shade and glare properties of the glass to be controlled manually or electronically, thus enhancing comfort and reducing energy consumption and greenhouse gas emissions. After closing on a Series A round, View replaced its founder, Paul Nguyen, as CEO and CTO. While in mediation over the termination, View proposed a new Series B round of funding, which under Section 242(b)(2) of the DGCL required the consent of Nguyen as holder of a majority of the common. The parties then signed a settlement agreement in which Nguyen consented to the Series B, subject to a seven day revocation right. When Nguyen discovered the terms of the Series B would materially diminish his rights, he revoked his consent within the revocation period. Unbeknownst to him, View had already closed on the Series B. Nguyen then brought an arbitration proceeding against View, seeking a declaration that the revocation was valid and the Series B funding invalid. While the arbitration was pending, View closed on additional rounds C through F in an aggregate amount of over $500 million. After View filed two certificates of validation under DGCL Section 204 seeking to ratify the increase in authorized capital, Nguyen commenced the Chancery Court suit, which the parties agreed to stay pending the arbitrator’s decision on the validity of the consent revocation.

The arbitrator ruled that the revocation was valid and the Series B invalid. The ruling effectively meant that all of the related transaction documents were likewise invalid and void because Nguyen had not consented to them either. And since each of the subsequent rounds of financing rested on the Series B funding, the invalidation of the Series B effectively invalidated the Series C through Series F rounds as well, basically blowing up View’s capital structure. The Series A stockholders responded by seeking to resurrect the funding rounds through the ratification provisions of Section 204, initially by converting their preferred shares into common (thus becoming the majority holders of the class) and then by authorizing the filing of certificates of validation with the Delaware Secretary of State under Section 204.

The key issue in the case was whether an act that the holder of a majority of shares of a class entitled to vote deliberately declined to authorize, but that the corporation nevertheless determined to pursue, may be deemed a “defective corporate act” under Section 204 that is subject to later validation by ratification of the stockholders, an issue of first impression.

In 2014, the Delaware legislature created two alternative pathways for corporations to cure defective corporate acts. Section 204 provides that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided [in Section 204] or validated by the Court of Chancery in a proceeding brought under Section 205.” Previously, acts deemed “voidable” could be subsequently ratified, but acts deemed “void”, such as the issuance of shares beyond what is authorized in a company’s charter, were deemed invalid. Prior to Sections 204 and 205, corporations had no way to remedy “void” corporate acts, even if the failure to properly authorize the act was inadvertent. The ability to cure defective acts is critical. Startups often need to clean up such acts prior to a funding round or acquisition, both to satisfy investor or acquirer due diligence issues and to enable counsel to issue opinion letters.

The court found that the Series B round was not a “defective corporate act” that is subject to ratification under Section 204 and ruled that View should not be allowed to invoke ratification to validate a deliberately unauthorized corporate act. As the holder of a majority of the outstanding common which was entitled to a class vote, Nguyen’s vote was required in order to authorize the Series B. The failure to obtain such authorization was not an oversight; it was the result of an affirmative rejection by Nguyen. Thus, the distinction here is between a defective corporate act that results from an oversight, which is curable under Section 204, and a defective corporate act resulting from an affirmative rejection by the stockholders, which is not curable under Section 204 (or 205).

One obvious takeaway is that companies should respect arbitrators’ rulings and should not proceed with a transaction, let alone a series of transactions, until stockholder authorization has been secured. View’s pursuit of the Series B round during the revocation period, and thereafter of the Series C through F rounds while the arbitrator’s ruling on the consent revocation was pending, was reckless to say the least. As the court put it, “[o]ne must presume that View understood that if the arbitrator found in favor of Nguyen on the consent issue, then the later rounds of financing that rested on the Series B Financing would collapse when that block was removed from the tower of blocks that comprised the Company’s preferred stock offerings”. One can only presume further that it did so against the advice of counsel or despite counsel’s warning of the risk.

The other takeaway here is that companies should consider carefully whether to opt out of the class vote requirement under DGCL Section 224(b)(2) for changes in capital structure. Section 224(b)(2) requires any increase or decrease in authorized shares to be approved by holders of a majority of each class of stock entitled to vote, but allows corporations to opt out by providing as much in the charter. The National Venture Capital Association’s model amended and restated certificate of incorporation has an optional provision that states that the common and preferred will vote together as a single class on all proposals to increase or decrease the authorized capital, irrespective of the provisions of Section 242(b)(2). Failure to opt out effectively provides the common stockholders with a veto over future capital raises because each subsequent round requires an amendment to the charter not just to create the new series of preferred, but also to increase the number of authorized common to accommodate conversion of the preferred. Failure to eliminate the class vote requirement will force the company to have to seek the consent of holders of a majority of the common, providing them with unintended leverage in connection with a deal that’s presumably in the best interests of the company and its shareholders.

]]>Cornell Tech Dedicates New Roosevelt Island Campushttps://www.lexblog.com/2017/09/13/cornell-tech-dedicates-new-roosevelt-island-campus/
Wed, 13 Sep 2017 20:18:41 +0000https://lexblognetwork.wpengine.com/2017/09/13/cornell-tech-dedicates-new-roosevelt-island-campus/Cornell Tech celebrated a historic milestone today with the dedication of its new campus on Roosevelt Island in New York City. A collaboration of Cornell University (yes, my law school) and The Technion – Israel Institute of Technology, the 12 acre applied science and engineering campus is one of the most significant additions to the NYC landscape in the last several decades and will help solidify the City’s claim as the number two technology hub behind only Silicon Valley.

Hard to believe it’s been six years since the splashy news conference in which Cornell and The Technion were introduced as the winners of what had become a grueling competition for who would build the new campus. That announcement was itself the culmination of a strategic process that started in 2008, when a study commissioned by then Mayor Bloomberg determined that the best opportunity to replace the thousands of jobs lost in New York City in the financial crisis was in the technology sector through the creation of startup incubators, accelerators and investment funds, and that the success of these initiatives depended on the recruitment and retention of talent. In response to the study’s recommendations, Mayor Bloomberg launched a competition to build an applied science campus in New York City with a focus on entrepreneurship and job creation, with the winner to receive $100 million (a mere fraction of the ultimate cost which turned out to be in the billions) and free land.

As would be expected, the campus has some of the most environmentally friendly and energy efficient buildings in the world. And as Technion President Peretz Lavie said to me, “the campus is the most beautiful I have ever seen”. High praise.

Cornell Tech’s mission is to create “pioneering leaders and technologies for the digital age, through research, technology commercialization, and graduate-level education at the professional masters, doctoral and postdoctoral levels.” The campus will undoubtedly have an enormous impact on the innovation ecosystem in the New York City area. It will serve as a tremendous pipeline for high end technology talent. Most tech startup founders would say that their single biggest challenge is recruiting and retaining talent. Many Cornell Tech graduates will be recruited into existing startups. Others will join big tech companies. Many others will be founders themselves, and it’s predicted that there will be 600 spinouts from the campus over the next three decades. Over 30 startups have spun out already in the digital technology space, spanning consumer applications, devices, medical, media and communications.

This is just the first stage of development of the campus, which is not expected to be completed until 2043. The current faculty of 30 tenured and 60 overall is expected to grow to four times as big, and the plan is to expand the student body, currently 300, to up to as many as 2,500.

The dedication ceremony can be viewed here. And here‘s a cool interactive 360° presentation.

]]>Unchained: Delaware Authorizes Blockchain Technology for Corporate Recordshttps://www.lexblog.com/2017/08/23/unchained-delaware-authorizes-blockchain-technology-for-corporate-records/
Thu, 24 Aug 2017 00:06:15 +0000https://lexblognetwork.wpengine.com/2017/08/23/unchained-delaware-authorizes-blockchain-technology-for-corporate-records/On August 1, 2017, Delaware became the first state to allow corporations to record issuances, transfers and ownership of stock using blockchain technology. Amendments to the Delaware General Corporation Law authorizing blockchain stock ledgers were passed by the Delaware State Senate and House of Representatives in June, signed by Governor John C. Carney Jr. in July and became law August 1. The amendments have enormous potential advantages for emerging companies, including cost savings, error avoidance, accuracy of ownership records and automation of administrative functions.

Blockchain is essentially an automated, decentralized, distributed database or ledger that allows participants on a given network to create an indelible, secure record of asset ownership and transfers directly and without the additional cost and delay associated with intermediaries. Each transaction is cryptographically signed and time stamped. While conventional transfers of assets typically require verification by third party intermediaries, blockchain based transfers rely on algorithms to confirm transaction authenticity.

Delaware law has required corporations to record stock transfers on a stock ledger and to maintain ownership records on the ledger. Stock ledgers are typically maintained by the corporate secretary or the company’s transfer agent who makes entries on paper or on an excel spreadsheet to reflect all transactions in the company’s stock. Under the current system, the corporate secretary or transfer agent must be notified of a stock issuance or transfer in order for the transfer to be recorded on the ledger and for the transferee to be treated as the record owner of the shares. The requirement for intermediaries to record stock transfers creates friction in the form of delay, expense and potential for error.

Prior to the blockchain amendments, Section 224 of the Delaware General Corporation Law provided that corporate records including stock ledgers could be maintained on any “information storage device”, but didn’t specifically allow for storage or recordation on electronic networks or databases, let alone any distributed electronic network or database. Section 224 has now been amended to provide that the information storage devices on which corporate records including stock ledgers could be stored may include “electronic networks or databases (including one or more distributed electronic networks or databases.”

The State of Delaware published an information sheet outlining the benefits to companies from registering issuances and transfers of shares in blockchain form, identifying three categories of benefits: cost savings, accurate ownership records and automation of administrative tasks. For privately held companies, maintaining a stock ledger on blockchain would:

So if a corporation organizing in Delaware elects to use blockchain technology for its stock ledger, the Division of Corporations would cryptographically transfer to the company on the distributed ledger just those shares identified in the corporation’s certificate of incorporation as authorized. By doing so, the Division of Corporations establishes a perfect record of authorized shares, and the distributed ledger then reliably tracks subsequent issuances by the company and transfers by stockholders to produce a reliable record of issued and outstanding shares.

Under existing methods of share transfer and ownership recordation, an issuance or transfer could easily slip through the cracks. It’s not uncommon to discover gaps in a company’s cap table, often at the most inopportune time such as on the eve of closing a transaction, where the company inadvertently issued a number of shares in excess of the amount authorized, thus triggering the necessity for a filing under Section 204 of the DGCL to cure the defective corporate act. Blockchain based stock ledgers would eliminate this possibility.

Finally, the amendments impose certain requirements on blockchain based stock ledgers. First, electronic corporate records must be capable of being converted into legible paper form within a reasonable period of time. Second, as required of other stock ledger formats, blockchain based ledgers must be able to (i) be used to prepare a list of stockholders entitled to vote, (ii) record information required by the DGCL to be maintained in the ledger and (iii) record transfers of stock pursuant to Article 8 of the Delaware Uniform Commercial Code.

]]>SEC Provides Initial Coin Offering Guidancehttps://www.lexblog.com/2017/08/08/sec-provides-initial-coin-offering-guidance/
Wed, 09 Aug 2017 03:39:52 +0000https://lexblognetwork.wpengine.com/2017/08/08/sec-provides-initial-coin-offering-guidance/On July 25, 2017, the SEC’s Division of Enforcement issued a Report of Investigation (the “Report”) that concluded that the tokens issued in an initial coin offering (“ICO”) by a decentralized autonomous organization called “The DAO” were “securities” and that the ICO itself should either have been registered with the SEC under the Securities Act of 1933 or qualified for an exemption therefrom. Importantly, the Report does not conclude that all ICO tokens are securities or that ICOs must either be registered or satisfy the requirements for an exemption from registration. The Report provides important guidance, however, to blockchain startups and other entities seeking to raise capital in the United States through ICOs as to how to structure those offerings from a regulatory standpoint.

Initial Coin Offerings

An initial coin offering is a crowdfunding technique used primarily by blockchain startups in which the issuer sells cryptocurrency tokens or coins that entitle the purchaser to certain rights ranging from access to the issuer’s product or service once it is available (similar to pre-order based non-equity crowdfunding on sites such as Kickstarter or Indiegogo) to a share in the issuer’s profits (similar to equity based crowdfunding). Purchasers also typically have the right to resell their tokens on an online exchange. Purchasers make their contributions in the form of either fiat currency (e.g., U.S. dollars) or, more typically, virtual currency (e.g., bitcoin or ether). The offering and sale of the tokens are made directly to the public using blockchain technology to bypass conventional capital markets intermediaries and regulatory regimes. Advertising and information releases occur on the issuer’s website and on online forums such as Bitcointalk and Reddit.

Looming over the emerging ICO industry is the issue of whether ICOs are offerings of securities. Some issuers have chosen not to take the risk of offering and selling unregistered securities in the United States and have instead offered and sold ICO tokens only to non-U.S. persons. Among the most popular non-U.S. markets are Singapore, one of the first jurisdictions to adopt a regulatory sandbox and other regulatory relief initiatives for fintech companies, and Switzerland, whose “Crypto Valley” is a major center of blockchain startups. Other issuers in the U.S. have attempted to steer clear of possible regulation by limiting rights of token holders to access to products or services upon availability.

The DAO Initial Coin Offering

The DAO was a virtual entity referred to as a decentralized autonomous organization (i.e., not a corporation, LLC or other legal entity) formed to sell virtual tokens to raise capital for future projects, a variation on an investment fund. DAO token holders would have the right to share in the earnings from the projects and could otherwise monetize their investments in DAO tokens by reselling them in online platforms serving as secondary markets. The idea behind this virtual organization was to replace traditional corporate governance and decision making with smart contract coding on a blockchain. But in addition to the automated governance structure, the DAO did have a human component as well in the form of “curators” who maintained ultimate control over which proposals would be submitted to and voted on by token holders and then funded by the DAO. A majority vote of the DAO token holders was required for a project to be funded.

The SEC’s Analysis

Section 5 of the Securities Act requires that every offer and sale of securities in the United States either be registered with the SEC or satisfy the requirements of an exemption from registration. But are ICO tokens securities? Under Section 2(a)(1) of the Securities Act, a security includes an “investment contract”, which was determined in the seminal case of SEC v. W.J. Howey Co. to mean an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. In determining whether an investment contract exists, the investment of “money” need not take the form of cash. Investors in the DAO used ETH to make their investments. The Report makes clear that such investment is the type of contribution of value that can create an investment contract under Howey.

The Report then found that investors who purchased DAO tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise when they contributed ETH to the DAO in exchange for DAO tokens. The DAO’s various promotional materials informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment. The Report also found that investors expected profits to be derived from the managerial efforts of others—specifically, the DAO’s founders and curators. Because the investors did have an ostensible management role – voting on proposed projects — the central issue was whether the efforts of “others” were undeniably significant and essential to the failure or success of the enterprise. In this regard, the Report found that the DAO’s investors relied on the managerial and entrepreneurial efforts of the founders and the DAO’s curators to manage the DAO and put forth project proposals that could generate profits for the investors. The founders of the DAO also held themselves out to investors as experts in Ethereum, the blockchain protocol on which the DAO operated, and told investors that they had selected persons to serve as curators based on their expertise and credentials. Although DAO token holders were afforded voting rights, the SEC determined that such rights did not provide the holders with meaningful control over the enterprise because (1) their ability to vote for contracts was largely “perfunctory” (they could only vote on proposals that had been cleared by the curators); and (2) their pseudonymity and dispersion made it difficult for them to communicate or join together to effect change or exercise meaningful control.

A second major issue weighing on the ICO industry has been whether the online platforms on which ICO tokens are traded need to be registered under the Securities Exchange Act of 1934 as national securities exchanges. Section 3(a)(1) of the Exchange Act defines an “exchange” as any group or entity that “provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange…”. Under Exchange Act Rule 3b-16(a), a trading system meets the definition of “exchange” under Section 3(a)(1) if the platform “(1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade”. Alternatively, a platform could operate as an alternative trading system exempted from the definition of “exchange” if it registers as a broker-dealer, files a Form ATS with the SEC to provide notice of its operations and complies with the other requirements of Regulation ATS. The Report concluded that the platforms on which the DAO tokens were traded were exchanges under the foregoing Rule 3b-16(a) criteria, and thus should have been registered, because they provided users with an electronic system that matched orders from multiple parties to buy and sell DAO tokens for execution based on non-discretionary methods.

Key Takeaways

It’s unclear why the SEC determined to issue an investigative report rather than pursue an enforcement action against the DAO, its promoters and the exchanges on which the ICO tokens were traded. The underlying conclusions, however, are not surprising. Virtual currencies such as bitcoin and ether are “value” and ICOs in which purchasers have a reasonable expectation of profit through the efforts of the issuer’s promoters are securities offerings which must either be registered or qualify for an exemption. Giving investors “perfunctory” voting rights on proposals presented by promoters’ agents will not be enough to overcome a presumption that the investors expect a profit through the efforts of others. It’s worth noting that the SEC did not address ICOs of so called “access tokens” in which purchasers are given only a right to future products or services but no opportunity for profit. Such ICOs would need to be structured very carefully to ensure that contributors have no “reasonable expectation of profit”, and it’s unclear whether as a practical matter issuers will be able to raise significant amounts without offering a profit incentive. Finally, the Report puts ICO platforms on notice that electronic systems that match orders from multiple parties to buy and sell tokens based on non-discretionary methods must register either as a national securities exchange or as a broker dealer under Regulation ATS.

]]>Do Private Company M&A Intermediaries Need to Register with the SEC as Broker-Dealers?https://www.lexblog.com/2017/07/17/do-private-company-ma-intermediaries-need-to-register-with-the-sec-as-broker-dealers/
Mon, 17 Jul 2017 13:49:47 +0000https://lexblognetwork.wpengine.com/2017/07/17/do-private-company-ma-intermediaries-need-to-register-with-the-sec-as-broker-dealers/Since 2014, many private company mergers and acquisitions intermediaries have chosen not to register as broker-dealers. That’s because a 2014 SEC no-action letter took the position that intermediaries that limited their activities to representing private companies in M&A deals were not required to register with the SEC as broker-dealers. But as a no-action letter, the relief provided was limited to the specific facts presented, and the letter implied that such relief would not be available to any intermediary that engaged in any of several listed activities. Greater certainty may be on the way, however, in the form of a small part of proposed legislation recently passed by the House of Representatives that would effectively codify the SEC’s 2014 no-action position and even expand on it.

Background

Section 15(a) of the Securities Exchange Act of 1934 requires any broker-dealer engaging in interstate commerce to register with the SEC and be subject to its regulatory regime. The term “broker” is defined broadly in Section 3(a)(4) of the Exchange Act to include any person who effects transactions in securities on behalf of others, and the SEC has historically interpreted the meaning of “effects transactions in securities” to include anyone engaged in significant aspects of a securities transaction, including solicitation, negotiation and execution. The inclusion of a transaction based or success fee has long been interpreted as a strong presumption that the intermediary receiving the fee must register as a broker-dealer.

So is an acquisition of a company considered to be a securities transaction such that intermediaries should have to register as broker-dealers? The broker-dealer regulations were designed to prevent abuses in the form of high pressure selling tactics and third party custody of funds, two aspects that typically don’t apply to M&A deals. Moreover, in a typical M&A transaction, unlike a stock trade, the acquiror usually engages in its own exhaustive due diligence of the target and the intermediary does not custody funds. Nevertheless, the U.S. Supreme Court thought otherwise and in 1985 opined that an M&A transaction involving a target’s stock is a securities transaction, and consequently many M&A advisors began registering as broker dealers.

The 2014 No-Action Letter

In the 2014 no-action letter, the SEC Division of Trading and Markets stated that it would not recommend enforcement action to the SEC if an intermediary were to effect securities transactions in connection with the transfer of ownership of a privately-held company. The letter listed a bunch of deal activities that would make the relief unavailable, however, including providing financing for the deal, custodying funds or securities, arranging for a group of buyers and sale of a company to a “passive” buyer.

Financial CHOICE Act of 2017

On June 8, 2017, the U.S. House of Representatives passed the Financial CHOICE Act of 2017, which repeals or modifies significant portions of Dodd-Frank but also includes a broad range of important provisions aimed at facilitating capital formation pro-growth policies generally, including an exemption from broker dealer registration for private company M&A intermediaries. Like the 2014 no-action letter, the Financial CHOICE Act would deny the exemption to any broker intermediating an acquisition of a shell company or a transaction involving the public offering of securities or engaging in the custody of funds or securities. But unlike the 2014 no-action letter, the Financial CHOICE Act would not exclude brokers that put together groups of buyers or provide acquisition financing, or intermediate a sale of a company to a passive acquiror. One feature present in the Financial CHOICE Act that was not included in the 2014 no-action letter is a size of target test. Specifically, under the Financial CHOICE Act, the exemption is only available if the target has gross revenues below $250 million and EBITDA below $25 million in the fiscal year ending immediately before the fiscal year in which the services of the M&A broker are initially engaged with respect to the transaction.

The legislation has moved to the Senate, and hopefully any final version would include some form of private company M&A broker-dealer registration exemption. Of particular significance in the proposed legislation is the apparent allowance for a non-registered broker to organize groups of buyers which would enable private equity club deals. Nevertheless, even if the legislation passes, private company intermediaries should consider carefully the consequences of non-registration (or withdrawal of those already registered). These would include complications under certain state regulatory regimes and exclusion from the possibility of intermediating public company deals or deals involving targets exceeding either the gross revenue or EBITDA thresholds.

]]>Good Choice: Important Capital Formation Reforms in Financial CHOICE Act of 2017 Passed by Househttps://www.lexblog.com/2017/06/25/good-choice-important-capital-formation-reforms-in-financial-choice-act-of-2017-passed-by-house/
Sun, 25 Jun 2017 21:41:09 +0000https://lexblognetwork.wpengine.com/2017/06/25/good-choice-important-capital-formation-reforms-in-financial-choice-act-of-2017-passed-by-house/On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;

Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;

Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;

Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;

Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;

Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;

Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;

Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;

Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;

Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and

Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

The fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

]]>Irredeemable: Delaware Case Will Make Redemption Rights Tougher to Enforcehttps://www.lexblog.com/2017/05/30/irredeemable-delaware-case-will-make-redemption-rights-tougher-to-enforce/
Tue, 30 May 2017 19:43:38 +0000https://lexblognetwork.wpengine.com/2017/05/30/irredeemable-delaware-case-will-make-redemption-rights-tougher-to-enforce/Venture capital funds routinely negotiate for a right of redemption – the right to require the company to buy out their shares after a certain period of time if an exit has not occurred – as a key element of their exit strategy. But according to a recent case in Delaware, the VCs and the company‘s board members could be liable to common stockholders if they cause the company to engage in transactions to generate funds for redemption to the detriment of the common stockholders.

Frederick Hsu Living Trust v. ODN Holding Corporation, et. al. involves a $150 million investment by venture capital firm Oak Hill Capital Partners in a holding company formed to own Oversee.net. The investment terms included a right in favor of Oak Hill to demand redemption of its shares for its $150 million investment amount beginning five years after the closing. The following year, the terms of the redemption feature were made more favorable to Oak Hill by imposing on the company a contractual obligation to “take all reasonable actions (as determined by the [company’s] Board of Directors in good faith and consistent with its fiduciary duties)” to raise capital if the funds legally available are insufficient to satisfy the company’s redemption obligation in full.

Not long after its initial investment, Oak Hill bought out one of the company’s founders and gained control over a majority of the company’s voting power and the board. The complaint alleged that, two years later, Oak Hill concluded that exercising its redemption right was the most effective way to achieve the return of its capital, that the company lacked the cash to redeem any shares and that the company should change its business plan from pursuing growth to accumulating cash in order to maximize redemptions. The company then stopped making acquisitions, sold off most of its profitable business lines, changed the management team and approved bonuses that would be payable if the company redeemed at least $75 million of preferred stock. The board subsequently approved and the company executed two redemptions in the aggregate amount of $85 million and paid related bonuses in the amount of approximately $2.4 million. Essentially, the complaint alleged that the directors breached their fiduciary duties by prioritizing the interests of the preferred stockholders over those of the common.

In cases involving directors’ fiduciary duties, courts will generally follow the business judgment rule and give deference to, and not second-guess, directors’ decisions. In cases where the board is not constituted with a majority of disinterested directors or otherwise does not act through a special committee of disinterested directors, however, directors’ actions are examined not by the business judgment rule but by the entire fairness standard, effectively shifting the burden to the defendants to establish both that the process and price were fair. In ODN Holding, none of the directors was deemed to be disinterested, so the focus of the case was on whether or not the process undertaken by the board was fair.

Under Delaware law, board members generally have a legal duty to advance the best interests of the corporation, meaning that they must seek to promote the value of the corporation for the benefit of its stockholders. But in a world of many types of stock and stockholders — record and beneficial holders, long-term holders, short term traders, activists – the question is: which stockholders? In his opinion in ODN Holding, Vice Chancellor Laster stated that a board’s obligation to promote the value of the corporation for the benefit of stockholders runs generally to the common stockholders as the residual claimants, which he said was justified because a corporation has a perpetual life and the common stockholders’ investment is locked in.

In ODN Holding, abandoning a growth strategy and selling off businesses was essentially a zero sum game: the cash generated by the sale of businesses benefited the preferred stockholders because it funded redemptions, but it hurt the common because it left the company without any means to sustain itself. The board chose to benefit the preferred at the expense of the common. But it could have chosen to keep the company intact, redeem preferred shares incrementally over the long run and thus leave open the possibility of creating residual value for the common. That strategy would have been unappealing to the preferred, who clearly wanted their capital returned sooner rather than later.

The court was careful to draw a distinction between preferred stockholders and lender/creditors. Unlike creditors, preferred stockholders have no legal right to fixed payments of interest and no maturity date with the prospect of capital repayment and remedies for default. The court went on to state that a redemption right, even one that has ripened, does not convert a preferred holder into a creditor, and doesn’t give the holder an absolute right to force the corporation to redeem its shares no matter what. That’s because redemption rights are subject to statutory, common law and contractual limitations. As a stockholder in a Delaware corporation, Oak Hill’s rights were subject to the requirements of Section 160 of the Delaware General Corporations Law. As a matter of common law, redemptions cannot be made when the corporation is, or would be rendered, insolvent. By contract, under the terms of the preferred stock itself, redemptions could only be made out of “funds legally available,” and the board only had an obligation to generate funds for redemptions through “reasonable actions” as determined by the board in good faith and consistent with its fiduciary duties.

The opinion states that a board does not owe fiduciary duties to preferred stockholders when considering whether or not to take corporate action that might trigger or circumvent the preferred stockholders’ contractual rights, i.e., redemption rights. Preferred stockholders are owed fiduciary duties only when they do not invoke their special contractual rights and instead rely only on rights shared equally with the common stock.

It should be noted that Oak Hill’s preferred stock did not carry a cumulative dividend, a common feature of preferred stock which would have otherwise steadily increased the amount of the liquidation preference. Had Oak Hill’s preferred stock included cumulative dividends, the board might have stronger grounds to conclude that there was no realistic scenario for the company ever to generate proceeds sufficient to satisfy the preferred’s liquidation preference (as supplemented by the cumulative dividends) and then to have any value left over for the common, in which case the board would have been justified in liquidating the company with all proceeds going to the preferred.

It also bears emphasizing that ODN Holding was decided on a motion to dismiss, a pleading-stage decision, in which the plaintiff is given the benefit of the doubt. The court left open the possibility that the trial court could find that, even without the obligation to pay cumulative dividends, the directors could have reasonably concluded that the company’s value as a going concern would never exceed Oak Hill’s $150 million liquidation preference and so selling substantially all the assets with all proceeds going to the preferred and nothing left for the common was defensible because the common was effectively worthless. But that issue would have to be determined at trial, not on a motion to dismiss.

Key Take-Aways: Companies should tread very carefully in embarking on a series of transactions to generate funds for redemption when the board is not constituted with a majority of disinterested directors. Directors must treat preferred stockholders, even those with ripened redemption rights, differently than creditors, whose contractual rights have far less legal restrictions and whose rights need not be balanced against those of the common stockholders. Where a board contemplates a course of action to benefit the preferred, they must be prepared to prove that doing so was value maximizing because the preferred holders’ liquidation preference exceeded the company’s value as a going concern, effectively rendering the common stock worthless. And finally, from the investors’ perspective, negotiating for and securing cumulative dividends would help bolster that last argument.